Morningstar - Q1 2024 - 34

Strategies
How to Invest Better With Bonds
Sharpening fixed-income portfolio
allocations can improve results.
Research
38
The Diminishing Role of Active
Mutual Funds
Quant U
42
Solving the Retirement Equations, Part IV
Best Ideas
47 Manager: A Different Approach to
Value Investing
48 Passive: Cautious but Crafty
49
Equity: An Attractive Transformation
SHARPE
Maciej Kowara and Alec Lucas
The emergence of Modern Portfolio Theory
in the 1950s revolutionized investing. Instead of
viewing stock or bond picks in isolation,
practitioners can now consider the direction and
extent to which security prices in a portfolio
change in relation to each other, or their
covariances and correlations. And they can aim to
maximize the portfolio's return while minimizing
its risk, defined as price volatility.
The Sharpe ratio-originally called the reward/
variability ratio but renamed for its creator,
Nobel laureate William F. Sharpe-has become
a key metric for assessing funds' or asset
classes' past or future performance. The ratio is
an annualized number that incorporates both
opportunity cost and risk. The numerator is
the average of the monthly return of each security
or portfolio in excess of a risk-free rate measure,
such as the three-month Treasury bill yield,
while the denominator is the standard deviation
of that excess return. True to its original name,
the metric gauges an investment's reward relative
to its volatility, whether that investment is a
stock or bond fund.
Although the higher the better, constructing an
optimal portfolio is not just a matter of choosing
the top asset classes in terms of Sharpe ratio.
Covariances and correlations matter across asset
classes, too. Thus, the Sharpe-optimal portfolio
is the one whose mix of asset classes maximizes
excess return relative to its standard deviation.
Given Modern Portfolio Theory's long-standing
influence and the Sharpe ratio's prominence,
one might assume that Sharpe-optimal portfolios
are the norm, but that's not the case. Using
Stocks, Bonds, Bills, and Inflation return data on
intermediate U.S. government bonds and
U.S. large-cap stocks since 1926 and optimizing
for Sharpe ratio leads not to the standard
60% stock/40% bond portfolio but to a 21% stock/
79% bond allocation.
The contemporary bond market's diversity allows
for an even smaller equity stake. Drawing on
Morningstar Indexes data since 2000 and sticking
to major U.S.-dollar-denominated asset classes,
optimizing for Sharpe ratio results in a 5%
stock allocation, far smaller than is typical in all
but the most conservative portfolios, and a bond
allocation whose subsector weightings look
quite different from the broad fixed-income market.
Academic theory suggests that investors who
want to increase portfolio returns beyond
what a 5% stock allocation would produce should
employ financial leverage.1
But that's hard
to implement in practice and courts considerable
risk if extreme market events exceed expectations.
So, to provide those investors with an
actionable alternative, we have instead opted to
use set minimum equity allocation percentages as
starting points (20%, 40%, 60%, and so on)
and then to Sharpe-optimize the rest of each
portfolio around that constraint.
Capital allocators, financial advisors, and
sophisticated investors who wish to implement
Sharpe-optimized portfolios will find examples
1 Asness, C.S., Frazzini, A., & Pedersen, L.H. 2012. " Leverage Aversion and Risk Parity. " Financial Analysts Journal, Vol. 68, No. 1, P. 47.
34
Morningstar Q1 2024
Morningstar - Q1 2024

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