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I. Introduction to expected return
II. The short version
III. Detailed methodologies
1. Building Blocks methodology
i. Methodology ii. Set-up in Direct Asset Allocation iii. Use case2. CAPM methodology
i. Methodology ii. Set-up in Direct Asset Allocation iii. Use case3. Black-Litterman methodology
i. Methodology ii. Set-up in Direct Asset Allocation iii. Use caseI. INTRODUCTION
The goal of optimization is to help an investor build an investment portfolio that provides a range of protection and
opportunity. To determine the composition of the optimal portfolio, one needs to know the nature of the possible
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known as optimization inputs. Optimizer inputs describe the probability distribution of future asset class returns and
take into account the risk contained in the various asset classes.Mean Variance Optimization requires three inputs:
Expected return of each asset.
Standard deviation of the returns.
Correlation between asset returns.
The expected return must be viewed as part of the description of the entire distribution (assuming a quadratic
distribution). Viewed alone, it measures the mean of the entire distribution of future outcomes. It may never be
achieved as an outcome at all. The standard deviation portrays the dispersion of possible outcomes around the
expected return. Correlation quantifies the relationship with other asset classes. To decide whether it makes sense to
invest in an asset class, all these elements must be viewed together, and compared with the nature of other asset
classes. Each input viewed alone is insufficient for solving the portfolio selection problem.You can use forecasts or historical statistics as inputs in Direct Asset Allocation. Historical estimates will tell us what
has happened while forecasted estimates will tell us what we expect to occur. While there may be reasons to expect
the future to repeat the past, historical inputs can be very time dependent and unstable as large structural or
regulatory changes may change how these asset classes behave. For example, the S&P 500 has performed between
36.12% and ȋ17.36% over a 5 year holding period between 1926 and 2001. If you were to model the expected return
with S&P 500 for a five year investment horizon, there would be a large range of values that you could select from.
In addition to using historical returns and user-specified returns, Direct Asset Allocation provides three models for
developing expected returns: Building Blocks, CAPM (Capital Asset Pricing Model), and Black-Litterman. We will detail
these models below.II. THE SHORT VERSION
Building Blocks and CAPM calculate forward-looking expected returns based on historical risk premiums and the
current market condition. In both methods, the expected return is calculated by adding together historical risk
premium(s) and the current risk free rate. Historical risk premiums are preferred over standard historical calculations
since risk premiums have been found to be more consistent and stable over time. With the relative stable nature of
risk premiums, you have more confidence predicting future returns. The major difference between Building Blocks and
CAPM is in the risk premium calculation. Building Blocks calculates risk premium(s) by taking the arithmetic difference
between two historical data series, while CAPM uses a regression approach.The third model, the Black-Litterman method is a powerful and flexible model for creating a set of expected returns
that in turn result in asset allocations that can be used in the real world. It can also incorporate a user's forward-
looking views of the market in the expected returns. A set of implied returns for each asset class are first calculated
from a given risk-free rate, market risk premium, and a set of market capitalization weights before the views are
applied to arrive at the Black-Litterman expected returns for each asset class.III. DETAILED METHODOLOGIES
Current risk free rates
IHPȎV ILUVP GLVŃXVV ŃXUUHQP ULVN IUHH UMPHVB FXUUHQP Risk Free Rates are used in all three models mentioned above as
current market expectations, for use in building expected returns, and are defined as the annual expected risk free
rates over a given investment horizon. Input Current Risk Free Rates in percent format and on an annual basis.By default, Direct Asset Allocation defines the Current Risk Free Rate as the current yield on a U.S. Treasury strip
(principal) with a maturity equal to the time horizon you specify in the Term box in the Baseline Settings subtab. For
example, if the term is chosen as short-term, the current risk free rate is the current yield on a U.S. zero coupon
Treasury bond that matures at least one year from today. The Treasury strip used is noted on the Historical Risk-Free
Rate box.
Alternatively, you can input risk free rates for short term, intermediate term and long term investment horizons directly
into the Current Risk Free Rate box.1. Building Blocks Methodology
i. MethodologyThe Building Blocks approach applies the techniques dHYHORSHG N\ HNNRPVRQ MQG 6LHJHOB HPȎV a method for determining
the expected returns of Asset Classes. The premise of Building Blocks is that the return of an asset class can be
broken down into several components which are more predictable than the asset class returns themselves. With the
Building Blocks model, the expected return on an asset class represents the sum of the current risk free rate and one
or more historical risk premia or building blocks. By combining current expectations with historical risk premia, you
take into account current market conditions (the economic expectations of investors) and historical market returns.
The use of risk premia versus a pure historical return increases the predictive power of the model since historical risk
premia are more stable over time than the pure historical return of an asset class.For Equity asset classes, the components are the risk free rate, the return you should expect for investing in equity
over bond, and the return you should expect for investing in small cap over large cap. For fixed income, the
components are the return you should expect for a riskless asset with any maturity component removed, the return
you should expect for investing for a given horizon, and the return you should expect for investing in Corporate over
Government bonds.
For example, the S&P 500 expected return is the sum of the Equity Risk Premium and the current yield on a zero-
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arithmetically. Please see the Estimates Sample Excel spreadsheet in Direct Learning Center for detailed examples.
Building Blocks - Equity
In the Set-up subtab, click the Building Block Equity radio button to refine equity assets with the Equity Building Blocks
model. The Equity Building Blocks model can be broken up into up to three components: Current Risk Free Rate, Equity
Risk Premium and a Custom Premium. The Custom Premium is a catch-all premium that captures the all types of risk
premia beyond the equity risk premium. In order to refine the expected return of an equity asset, you can add two or
more of these premiums together.Example: Refining Small Equity
E(R) Small Equity = Current Risk Free Rate + Equity Risk Prem + Custom Prem Risk Free = Current risk free rate expectation for your investment horizon Equity Risk = Historical premium for investing in risky equities = (Domestic Equity Premia Baseline Series) ȋ (Historical Risk Free Rate series) Custom Prem = Historical premium for investing in risky small company stocks = (Asset class to refine) ȋ (Domestic Equity PBS)Building Blocks - Fixed Income
Horizon
Premium
Default
Premium
Equity
RiskPremium
Small StockPremium
T-Bills
Long Term
LargeStocks
Corporate
Bonds SmallStocks
Current Risk Free Rate
In the Set-up subtab, click the Building Block Fixed Income radio button to refine fixed-income assets with the Fixed
Income Building Blocks model. The Fixed Income Building Blocks model is broken up into three risk premiums: Cash,
Bond Horizon Premium and Bond Default Premium. In order to refine the expected return of a fixed-income asset, you
can add one or more of these premiums together.Example: Refining Long-term Corporate Bonds
Let's refine the expected return of Long-term Corporate Bonds. This asset has an average maturity of 20 years.
Expected Return = Cash + Horizon + Default
Cash = Current risk free rate for your investment horizon with the maturity component removed = (Current Risk Free Rate) ȋ (Horizon Premium) where, Horizon Premium = (Historical Risk Free Rate) ȋ (Horizon PBS)Horizon = Historical premium for investing in longer maturity bonds. Match the maturity of the asset
with the Horizon box (min 0, max 20) in the Set-Up Building Block Fixed Income area.If the Horizon = 1 ,5, 20
= (Historical Risk Free Rate series) ȋ (Horizon PBS) where, Historical Risk free rate series matches the maturity of the Horizon box. If you change the Horizon to 20, for example, the software will use the Long Term Historical Risk Free rate series.If the Horizon = 2-4, 6-9, 11-19
= Horizon premium is calculated using the following interpolation formula: = X Year Horizon Premium=A + B/X + C*X The 3 variables (A,B,C) are solved for using a series of 3 equations with 3 unknown variables (A, B, C) and three known variables (1, 5 and 20 Year Horizon premium):1 Year Horizon Premium=A + B/1 + C*1
5 Year Horizon Premium=A + B/5 + C*5
20 Year Horizon Premium=A + B/20 + C*20
Once you calculate the three variables, enter them into the interpolation formula and then solve for the Horizon Premium. Default = Historical premium for investing in risky corporate bonds in order to compensates for the possibility of default. = (Asset class to refine) ȋ (Default Premium PBS) ii. Set-Up in Direct Asset AllocationBaseline Settings subtab
The Baseline Settings subtab is the second tab under the Arithmetic Mean tab. In this subtab, you can specify
background information for the Building Blocks, CAPM, and Black-Litterman models. For these models you can select
the investment horizon/term, enter current risk-free rates and select historical risk-free rates and premia baseline
series. TermThe Term is specified in Baseline Settings subtab. The term is the expected length of time or investment horizon you
will hold your portfolio for. You can choose between short term, intermediate term and long term investment horizons.
When you choose a specific horizon, it determines the current risk free rate and the Historical Risk Free Rate series
used to build expected returns (Building Blocks, CAPM, and Black-Litterman models).For example, if you choose Long Term as your investment horizon, Direct Asset Allocation utilizes the Long Term
Current Risk Free Rate and the Long Term Historical Risk Free Rate data when refining the expected return for an
asset.To select an investment horizon, choose Short Term, Intermediate Term or Long Term in the Term drop-down box.
Current Risk Free Rate
Current Risk Free Rates can be entered in the Baseline Settings subtab. The Current Risk Free Rate is defined as the
annual expected risk free rate over a given investment horizon. The Building Blocks, CAPM, and Black-Litterman
models utilize these rates as current market expectations for use in building expected returns. If you would like to
overwrite the default values, you can input risk free rates for short term, intermediate term and long term investment
horizons directly into the three Current Risk Free Rate boxes. Input Current Risk Free Rates in percent format and on an
annual basis.Frequency Converting the Current Risk Free Rate
Direct Asset Allocation frequency converts the annual Current Risk Free when your expected return calculation is
performed on a monthly, quarterly or semi-annual basis. The frequency conversion is done on a compound basis:
where x = 1 if Monthly3 if Quarterly
6 if Semi-Annual
iii. Use Case Use Case 1: Steps to refine with the Building Blocks model1. In the Set-Up subtab under Arithmetic Mean tab, select the Building Blocks models (Equity or Fixed Income)
for the desired assets.2. In the Baseline Settings subtab, select your term for your investment horizon and risk free rates, choose your
Premia Baseline Series.
3. Click the Set-Up subtab again and then expand the Building Block Equity or Fixed Income bar. The calculated
Expected Return will show on the monthly basis. If you wish to exclude a certain risk premium, uncheck the
appropriate premium box.Note: For the Horizon premium in a Fixed Income model, you need to change the Horizon box to match the
maturity of the asset class(es) you are refining.4. Click the Input Summary tab to view the resulting annualized expected returns.
Use Case 2: Change Premia Baseline Series
The following is an example on using the Premia Baseline Series and Historical Risk Free Rate Series. In the Building
Blocks Equity model, the Equity Risk Premium is defined as: Equity Risk Prem. = (Domestic Equity Premia Baseline Series) - (Hist. Risk Free Rate)By default, the Domestic Equity Premia Baseline Series is defined as the S&P 500 total return series. The S&P 500
index does not include the whole market capitalization of the U.S. equity market. For example, you may feel that the
Wilshire 5000 better represents the U.S. equity market since it represents nearly 100% of the market capitalization of
all the publicly traded companies in the United States. To change the series, click on the Domestic Equity Premia
Baseline Series button. From the select proxy window, choose Wilshire 5000 total market return and click OK. The
Equity Risk Premium will now be calculated using the Wilshire 5000 instead of the S&P 500.2. CAPM Methodology
i. MethodologyThe capital asset pricing (CAPM) model NXLOGV RQ +MUU\ 0MUNRRLP]ȎV RRUN RQ PRGHUQ SRUPIROLR POHRU\, and was
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