ur survey of portfolio theories continues; we have already evaluated Modern Portfolio Theory, the Capital Asset Pricing Model and the Arbitrage Pricing Theory in earlier blogs, and now turn to a series of articles on Behavioral Portfolio Theory (BPT).
We left off last time showing how the Security Characteristic Line indicates the beta of an asset under Harry Markowitz’s Modern Portfolio Theory (MPT). We are now ready to discuss asset pricing models, and we’ll begin by documenting the Capital Asset Pricing Model (CAPM). This model was developed in the 1960’s by several independent researchers, including Sharpe, Treynor, Lintner and Mossin, building on Markowitz’s previous work.
CAPM is an equation that indicates the required rate of return (ROR) one should demand for holding a risky asset as part of a diversified portfolio, based on the asset’s beta. If CAPM indicates a rate of return that is different from that predicted using other criteria (such as P/E ratios or stock charts), then one should, in theory, buy or sell the asset depending on the relationship of the different estimates. For instance, if stock charting indicates that the ROR on Asset A should be 13% but CAPM estimates only a 9% ROR, one should sell or short the asset, which cumulatively should drive the price of Asset A down. Continue reading “Capital Asset Pricing Model, Part One – Normal Distribution” »
Our quest continues to find out whether hedge fund alpha really exists or is just hype. Recall from last time our documentation of the Capital Market Line (CML). The CML represents a portfolio containing some mixture of the Market Portfolio (MP) and the risk-free rate. It is aspecial version of the Capital Asset Line, ranging from the risk-free rate tangentially to the Efficient Frontier at the Market Portfolio, and then extending upwards beyond the tangent point. Modern Portfolio Theory (MPT) posits that any point on the CML has superior risk/return attributes over any point on the Efficient Frontier. Let’s ponder that for a second – just adding some T-Bills to, say, S&P 500 baskets (our proxy for the Market Portfolio) will improve the risk/return characteristics of your portfolio.
If your entire portfolio consisted only of the cash-purchased Market Portfolio (i.e. the tangent point on the Efficient Frontier), your leverage ratio would be 1 – you are unleveraged. The points on the CML below the Market Portfolio represent deleveraging: adding cash to your portfolio. You are lowering risk and expected return when you deleverage. If you borrowed and sold TBills, and used the proceeds to buy additional Market Portfolio, your new portfolio would be leveraged, and would be a point on the CML above the tangent. Leveraging increases your risk and expected return. If you disregard the effects of borrowing (or margin) costs, then all points on the CML share the maximum Sharpe Ratio, a popular formula for expressing risk/return. Continue reading “Modern Portfolio Theory – Part Three” »
Our risk/return series continues with a review of Modern Portfolio Theory (MPT). We’ve already looked at alpha, beta, efficient markets, and returns. Our ultimate goal is to evaluate the role of alpha in hedge fund profitability, how to replicate hedge fund results without needing alpha, and finally how you can start your own cutting-edge hedge fund using beta-only replication techniques.
MPT suggests that a portfolio can be optimized in terms of risk and return by carefully mixing individual investments that have widely differing betas. Recall that beta is return due to correlation with an overall market (known as systematic risk). To take a trivial example, if you hold equal long and short positions in the S&P 500 index, your portfolio would have an overall beta of (.5 * 1 + .5 * -1) = 0. There would be no risk, but in this case, there would be no return either, except for the slow drain of commissions, fees, etc.