Rational Investing by Langlois Hugues; Lussier Jacques;

Author:Langlois, Hugues; Lussier, Jacques;
Language: eng
Format: epub
Tags: BUS036060, Business & Economics/Investments & Securities/Stocks, BUS027000, Business & Economics/Finance
Publisher: Columbia University Press
Published: 2017-03-07T05:00:00+00:00

6

Building Better Portfolios

IN THIS CHAPTER, WE focus on what it all comes down to: building better portfolios and analyzing their performance. We consider two investors with different constraints: an institutional investor who is relatively unconstrained in the type of assets he can trade and allocations he can adopt, and a retail investor who is relatively more constrained.

We build portfolios based on the blueprint for long-term performance set out in chapter 5. Our objective is twofold. Of course, we examine the ability of an investor to invest by himself and generate value. However, the results of this chapter are also useful because of the benchmarks they provide. These benchmarks should be used when making a decision to hire a fund manager, listen to a professional forecaster, or even determine the efficiency limits of what can be achieved in portfolio management. Indeed, once we understand how and why we can build better portfolios, we can still delegate the management of our portfolio, but our expectations should have correspondingly increased and our tolerance for high fees declined.

The main conclusion of chapter 5 was that we should hold a combination of well-diversified risk factors. This next section discusses how to construct such risk factors. Then we will consider how an institution like a mutual or a hedge fund can significantly increase its risk-adjusted performance by adequately combining these risk factors into a stock portfolio.

We’ll then examine different portfolio solutions offered in the market and show how each one combines risk factors intelligently. Our discussion of a portfolio of U.S. equities will be useful to examine the relative merits of alternative weighting mechanisms that are being offered to investors.

We repeat our exercise by examining the performance of a portfolio that invests in risk factors across different asset classes: U.S. and international stocks, government bonds, commodities, and currencies. These portfolios would likely be appropriate for a sophisticated institution with the internal ability to implement an investment strategy, which requires programming skills, standard databases, and execution capabilities.

We next turn to our second category of investors. We have in mind as a good representation of this group a retail investor investing his personal savings; an investor with basic knowledge of Excel, who has limited time to spend on managing his portfolio and who is more restricted in terms of investment universe and borrowing limit. This investor faces higher transaction costs than an institution, which will force him to invest in exchange traded funds. He also cannot use any funding, which prevents him from shorting securities or using leverage. We’ll use this investor to explore whether or not to hedge currency risk, but our conclusions will also apply to institutional investors.

These examples will take advantage of the current investment and statistical literature. We show the impact of using robust statistical predictions of expected returns across asset classes and using risk models with varying degree of sophistication.

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