PORTFOLIO MANAGEMENT CHALLENGE PORTFOLIO OPTIMISATION STEP BY STEP GUIDE This document is designed to give you a step by step

guidance to the implementation of the Portfolio Management Challenge task. Step1. As described in the Workshops/Seminars, you need to begin by setting out your Investment process, since this will govern the way in which you select the markets or securities which you wish to include in your portfolio. Step2. You will need to understand the nature of the Benchmark Index. To help you with this, and to ensure that you all have the same base data, we have a factsheet on BlackBoard with the historical data for the MSCI World Index and its regional components: North America (54.72%); Europe Ex UK (19.65%); UK (9.84%); Pacific Ex Japan (5.85%); Japan (9.94%). The initial data is 4 years of month-end index price data in US$ terms, so you will have also download the equivalent end-of day /US$ exchanges rates. These should be the Reuters 4pm exchange rates which are the ones which are used in the index. NB If you wish to use a different frequency or a different period-end for the data, you will need to download this from the MSCI website and/or from DataStream. You will need to run the bootstrapping simulation exercise to generate a long-run time series of data for the benchmark and all of the components and then, using the Black-Litterman spreadsheet, calculate the implied equilibrium returns for the regional sub-components. (The simulation will give you the co-variance matrix and the spreadsheet has the regional weights)

Step 4. For the specific assets that you have analysed you will also need to download at least 3 years of month-end data for each of the asset classes, markets or individual securities that you have selected. NB. It is preferable not to use daily data as the market closings are all at different times and you will get too much estimation error in your correlation coefficients. You then need to conduct the boot-strapping exercise to generate a long period of simulated data for these assets Step 5. Use the output from the above to run regression analyses for each of your selected assets against the MSCI World benchmark data. This will enable you to obtain historical estimates of Alphas, Betas and residual risks.

THE NEXT STEPS WILL BE DIFFERENT, DEPENDENT UPON THE NATURE OF THE PORTFOLIO THAT YOU ARE CREATING. PLEASE THEREFORE ENSURE THAT YOU ARE IMPLEMENTING THE CORRECT STEPS 1. Where teams have stayed within the benchmark in terms of selecting countries or stocks a. If you are building a portfolio of, say, Hong Kong or European stocks or some other region, you can either use the Treynor-BlackB approach to combine the securities with the Pacific Ex Japan (or the Europe Ex-UK etc) part of the benchmark or you can take a more aggressive approach by constructing a portfolio containing only your selected stocks. If you choose to take the second approach, then you should optimise this part of the portfolio to maximise the Adjusted Sharpe Ratio. You can then either replace the Pacific ex Japan (or Europe Ex-UK etc) component of the benchmark with this portfolio or add it as an additional risk asset. You can then use Excel Solver to optimise the portfolio to maximise the expected return subject to the Tracking Error constraint; the limits on position size; and the maximum gearing.

As discussed in the Workshops, you may also wish to include some minimum exposure constraints on your preferred investment areas.

b. If you have used a macro top-down approach to make forecasts of market returns for certain markets within the benchmark, then the correct approach is to use the Black-Litterman model to incorporate your views with the historic implied views to give the new expected returns and then proceed to optimise using Solver to maximise the expected return subject to the Tracking Error constraint; the limits on position size; and the maximum gearing. Note that you will need to ensure that your forecast returns are noticeably above or below the BL implied returns in order to ensure that your final portfolio is appropriately skewed towards your favoured markets.

2. For teams who are investing in assets falling outside the benchmark Here, since you have the implied returns for the components of the benchmark and their weights, you also have the implied return for the benchmark. As a starting point you can then use the Treynor-Black spreadsheet to determine suggested portfolio weights. In order to obtain a final version of the portfolio, however, you will need to optimise using Solver to maximise the expected return subject to the Tracking Error constraint; the limits on position size; and the maximum gearing. In this optimisation we would suggest that you include the regional components of the benchmark rather than the whole benchmark. As discussed in the Workshops, you may also wish to include some minimum exposure constraints on your preferred investment areas.