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Fundamentals Drive Alpha

Presentation to the NYU Economics Honors Society Discussion Series


April 12, 2006

This talk is based on a paper, Fundamentals Drive Alpha co-authored by: Andrew Alford, PhD Bob Jones, CFA Terence Lim, PhD, CFA, CPA Bob Litterman, PhD The paper is available at: http://activealpha.gs.com/structured_equity.html

This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell, or the solicitation of offers to buy, any security. Opinions expressed herein are current as of the date appearing in this material.

What motivated the Black-Litterman model?

Optimizers are very powerful, sometimes very sensitive tools Investors had, historically, found optimizers didnt add much value to portfolio construction or asset allocation because the results were badly behaved

In 1989 I posed a question to Fischer Black:


Our asset allocation optimizer is extremely sensitive to its inputs. What can we do?

Black responded: Ive just written a paper using a Global CAPM framework to analyze currency hedging. Perhaps we should embed the optimization in the context of such an equilibrium I pondered Blacks suggestion and thought: I wonder what that means?

Fundamentals Drive Alpha

The Black-Litterman model

The answer begins almost 30 years earlier with Theil and Goldberger (1961) On Pure and Mixed Statistical Estimation in Econometrics. They describe how to combine Prior Information with a Sample. This well known formula is called mixed estimation Black and Litterman (1992) Global Portfolio Optimization use the same formula to combine a prior, Equilibrium with an investors Views The Global CAPM Equilibrium becomes the center of gravity for expected returns. Views specified by the investor pull expected returns away from the equilibrium values along curved paths defined by the covariance structure of the underlying asset returns Not only does the equilibrium make economic sense, but when those expected returns are used to drive the optimizer, the optimizer stops misbehaving

Fundamentals Drive Alpha

An advertisement for our book


(where, in 626 pages, we provide more details)

Fundamentals Drive Alpha

This diagram shows where Black-Litterman fits into our Quantitative Equity process
Quantitative Analysis of Fundamental Factors
View Portfolios

Current Portfolio Risk Allocation Risk Model

BlackLitterman
Optimal Tilt Portfolio

Transaction cost estimates

Reverse Optimization

Implied stock alphas

Optimization

Optimal Trades

Client objectives

Constraints

Fundamentals Drive Alpha

View portfolios

Views are represented as mathematical statements: A particular portfolio, p, has a particular expected return q The investor provides a set of such views (defined by a kxn matrix P containing the weights of the portfolios), a k-vector Q of expected returns for the portfolios, and the Covariance Structure for these View Portfolios We write: P m = Q + e e ~ N( 0, W )

Where m is the vector of expected returns for individual assets Each row of P reflects a view: that the portfolio with the given weights has the given expected return W specifies, along the diagonal, the degree of uncertainty about the view. We call its inverse the confidence in the view. (We can also use the off-diagonal elements of W to specify views for which the degrees of confidence should be related)

Fundamentals Drive Alpha

The Black-Litterman formula

Using the Theil-Goldberger formula, Black-Litterman combines the Views with a prior reflecting the global CAPM Equilibrium: m = P + ee P is the n-vector of equilibrium risk premia from Fischers Universal Hedging global CAPM. ee reflects the degree of uncertainty in the prior that expected returns have equilibrium values We assume the uncertainty about the means has a covariance structure, tS, proportional to S, the covariance matrix of asset returns

The result is a vector of expected returns:

m* = [(tS )-1 + PW-1P] -1 [(tS )-1P + PW-1Q]

which can be used as input to an optimizer.

Fundamentals Drive Alpha

Traditional asset allocation optimization


We illustrate the traditional approach to asset allocation in a world with 4 equity markets. The equity markets: ( US, Japan, UK, Germany) 1) Make assumptions about expected returns Attempt to express a bullish view on the US market Expected Returns Above the Risk Free Rate US = 4%; Japan = 3%; UK = 3%; Germany = 3%; 2) Estimate Volatilities and Correlations: Vols: US = 15%; Japan = 17%; UK = 16%; Germany = 15%; Corrs: US/Japan = .45; US/UK = .3; US/Germany = .25

Japan/UK = .4; Japan/Germany = .45; UK/Germany = .3


Optimal Portfolio Weights
60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% US Japan UK Germany
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Black-Litterman and asset allocation

We illustrate two views in a world with 4 equity markets. The equity markets: ( US, Japan, UK, Germany) 1) Bullish US equities (1 percent above equilibrium ) (1, 0, 0, 0) * m = (p1 + .01) + e1 2) Japan equities to outperform UK equities by 1 percent (0, 1, -1, 0) * m = .01 + e2
Equilibrium Expected Returns vs The Black-Litterman Expected Return Vector: m*
6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% US Japan UK Germany Equilibrium Black-Litterman

Fundamentals Drive Alpha

The Optimal Tilt Portfolio

The mean-variance optimal portfolio in an unconstrained context based on the BlackLitterman expected returns is a tilt away from a scaled Market portfolio toward a linear combination of the View Portfolios. We call the deviations from market capitalization weights the Optimal Tilt Portfolio. As shown in He and Litterman(1999), the OTP is a linear combination of the View Portfolios and the Market Portfolio
Portfolio Deviations Based on View Portfolio 1 0.12 0.10 0.08 0.06 0.04 0.02 0.00 -0.02 -0.04 -0.06 US Japan UK Germany
0.12 0.10 0.08 0.06 0.04 0.02 0.00 -0.02 -0.04 -0.06 US Japan UK Germany Portfolio Deviations Based on View Portfolio 2

Optimal Tilt Portfolio 0.12 0.10 0.08 0.06 0.04 0.02 0.00 -0.02 -0.04 -0.06 US Japan UK Germany
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Black-Litterman and active stock selection

If (1) the View Portfolios are uncorrelated with the Market and (2) the Optimal Portfolio is constrained to have zero beta,

Then the Optimal Tilt Portfolio is simply a weighted average of the View Portfolios. In this case, (and assuming there are no other binding constraints) the optimal active weights are proportional to the Optimal Tilt Portfolio.

You might well ask, Wheres the Juice? Equilibrium returns are no longer even part of the equation.

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Capturing views in client stock portfolios: The Black-Litterman framework

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Fundamentals drive alpha!

Capital markets are competitive, but not entirely efficient. However, beating the market is not easy. We believe the key driver of superior investment performance is superior fundamental research. Fundamental characteristics should be robust. We start with characteristics that are Economically Intuitive, then we conduct empirical tests To be considered an alpha driver, characteristics should demonstrate that they identify stocks with superior returns over time in different regions, economic environments, and market segments. Superior returns are captured through careful portfolio construction and trading We use the Black-Litterman framework and customized quantitative tools to enhance portfolio efficiency and minimize trading costs

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Lots of fundamental stock characteristics help determine value


Interest Coverage Price Momentum Beta Return on Equity Earnings Surprise Accruals Price/Earnings

Payout Ratio P/E to Growth

Earnings Momentum

Size

XYZs Value

Dividend Discount Model

Price to Cash Flow

Price / Book

Debt / Equity

Dividend Yield Long Term Growth

Expected Growth

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A few stock characteristics also help to forecast returns


This is a surprise: It should not happen in efficient markets

Accruals

Price Momentum

P/E to Growth

Price/Earnings

Return on Equity

XYZs Alpha
Earnings Momentum

Price / Book

Price to Cash Flow

Dividend Discount Model

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Most stock characteristics dont forecast returns


The information they contain is, on average, fully reflected in current prices

Beta

Payout Ratio

Size

Interest Coverage

Debt / Equity

XYZs Value

Dividend Yield

Expected Growth

Long Term Growth

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We express our investment insights as views

We have views about fundamental characteristics, not individual stocks.

We believe portfolios of stocks with positive alpha drivers will outperform portfolios of stocks with negative alpha drivers.

Translating views into portfolios is not easy. The alpha drivers have different expected returns and risks. Individual stocks have unequal, and sometimes offsetting, fundamental characteristics. Many investors use a simplistic approach that ignores risk: The stronger a stocks fundamentals

The larger the view


The bigger the stocks position Our process combines fundamental characteristics to maximize portfolios information ratio.

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View portfolios capture the information in the alpha drivers

Our process over-weights stocks with good fundamentals and under-weights stocks with poor fundamentals

We form multiple view portfolios, one for each alpha driver The view portfolios are long (short) stocks with positive (negative) values for the corresponding alpha drivers Each view portfolio has a given exposure to the corresponding alpha driver and minimizes exposure to other sources of risk View portfolios have superior returns because they have attractive fundamentals and limited risk

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What does a stock selection view portfolio look like?

Its really up to the investor. We think View Portfolios should represent fundamental characteristics that forecast returns, for example, operating efficiency If you believe this characteristic forecasts higher future returns, then you can imbed this belief in a View Portfolio.

Industry Normalized Operating Efficiency


Standardized Exposures
1.50 1.00 0.50 0.00 (0.50) (1.00) (1.50) (2.00)
AMERICAN INTERNATIONAL GROUP INTERNATIONAL BUSINESS MACHINES CORP CITIGROUP INC EXXON MOBIL CORPORATION WAL-MART STORES INC PFIZER INC BANK OF AMERICA CORP GENERAL ELECTRIC CO MICROSOFT CORP JOHNSON & JOHNSON

(2.50)

The data above is for illustrative purposes only and is not a recommendation of any security.

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Active Weight
1.500 1.000 0.500 0.000 -0.500 -1.000 -1.500

Active Weights

Active Weights
0.00 0.50 1.00 1.50 (2.50) (2.00) (1.50) (1.00) (0.50)

EXXON MOBIL CORPORATION

JOHNSON & JOHNSON

WAL-MART STORES INC

BANK OF AMERICA CORP

AMERICAN INTERNATIONAL GROUP INTERNATIONAL BUSINESS MACHINES CORP

Weights Based on Factor Values

Weights Based on Factor Ranks

Minimum Risk Exposure to Factor

The data above is for illustrative purposes only and is not a recommendation of any security.
PFIZER INC CITIGROUP INC MICROSOFT CORP

There are different approaches to setting the weights in view portfolios

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GENERAL ELECTRIC CO

1.5 1 0.5 0 -0.5 -1 -1.5 -2 -2.5


EXXON MOBIL CORPORATION JOHNSON & JOHNSON WAL-MART STORES INC BANK OF AMERICA CORP AMERICAN INTERNATIONAL GROUP INTERNATIONAL BUSINESS MACHINES CORP PFIZER INC CITIGROUP INC MICROSOFT CORP GENERAL ELECTRIC CO

EXXON MOBIL CORPORATION

JOHNSON & JOHNSON

WAL-MART STORES INC

BANK OF AMERICA CORP

AMERICAN INTERNATIONAL GROUP INTERNATIONAL BUSINESS MACHINES CORP

PFIZER INC

CITIGROUP INC

MICROSOFT CORP

GENERAL ELECTRIC CO

Historical effectiveness of each alpha driver

Simulated excess returns to CORE themes (June 1977 to September 2004)

70%

Valuation
60% 50%

Earnings Quality Momentum Analyst Sentiment Profitability

Cumulative Return

40% 30% 20% 10% 0% -10%

Management Impact

1977

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The performance results stated above are backtested based on a methodology that is derived from an analysis of past market data with the benefit of hindsight. These results do not reflect the performance of a GSAM managed account or composite and are being shown for informational purposes only. If GSAM had managed your account during the period shown above it is highly improbable that your account would have been managed in a similar fashion due to differences in economic and market conditions. The performance results disclosed herein do not represent the results of actual trading using client assets. The backtested performance results depicted above reflect the reinvestment of dividends and other earnings, but do not reflect the deduction of advisory fees, brokerage or other commissions or exchange fees or any other expenses a client would have to pay. Source: Goldman Sachs.

2004

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Combining view portfolios

The Black-Litterman framework delivers a robust combination of view portfolios The weights in the Optimal Tilt Portfolio (OTP) are driven by a number of considerations. We allocate more risk to view portfolios (alpha drivers) with: Better historical results More consistent results Stronger confidence (lower uncertainty) Greater diversification benefits Longer signal persistence

Lower required turnover

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Limitations of the optimal tilt portfolio

In an ideal world, a clients portfolio would be the benchmark plus the OTP Portfolio weight = Benchmark weight + OTP weight

Unfortunately, the OTP is not appropriate for most clients: The OTP is a zero-investment, long-short portfolio The OTP does not reflect client-specific guidelines and restrictions The OTP ignores transaction costs

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Consistency with the risk model

The Black-Litterman framework produces individual stock alphas, based on the OTP, that are consistent with the risk model. They are, in effect, a reverse-optimization of the OTP based on the same risk model.

We believe that risk models play a central part throughout the investment process They should be applied consistently when creating the OTP and stock alphas, as well as in the final portfolio optimization step with client objectives, constraints, and transactions costs They should be robust: We estimate our risk models using a parsimonious factor structure, we use daily data, and we use shrinkage estimators Our risk models are customized and proprietary: they measure the unique risks in our view portfolios. How else could one expect to accurately allocate risk across those factors? Comparing two managers who have the same fundamental views, the one who captures those views most efficiently, through better risk modeling and portfolio construction, will be more successful

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This diagram shows where Black-Litterman fits into our Quantitative Equity process
Quantitative Analysis of Fundamental Factors

View Portfolios

Risk Allocation

W
Risk Model

Current Portfolio

BlackLitterman
Optimal Tilt Portfolio

Transaction cost estimates

m*
Reverse Optimization Implied stock alphas Optimization Optimal Trades

Client objectives

Constraints

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References

Black, F., and Litterman, R. 1992. Global Portfolio Optimization. Financial Analysts Journal 48 (September/October): 28-43 He, G., and Litterman, R. 1999. The Intuition behind Black-Litterman Model Portfolios. Goldman Sachs Investment Management Series. Theil, H., Goldberger, A.S., 1961. On pure and mixed estimation in econometrics. International Economic Review 2, 6578.

References

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Additional information

General Opinions expressed are current opinions as of the date appearing in this material only. No part of this material may, without Goldman Sachs Asset Managements prior written consent, be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorized agent of the recipient. In the event any of the assumptions used in this presentation do not prove to be true, results are likely to vary substantially from the examples shown herein. These examples are for illustrative purposes only and do not purport to show actual results. This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell, or the solicitation of offers to buy, any security. Opinions expressed herein are current as of the date appearing in this material. Expected returns are statistical estimates of hypothetical average returns of economic asset classes, derived from statistical models. Actual returns are likely to vary from expected returns. Expected return models apply statistical methods and a series of fixed assumptions to derive estimates of hypothetical average asset class performance. Reasonable people may disagree about the appropriate statistical model and fixed assumptions. These models have limitations, as the assumptions may not be consensus views, or the model may not be updated to reflect current economic or market conditions. Accordingly, these models should not be relied upon to make predictions of actual future account performance. Goldman Sachs has no obligation to provide recipients hereof with updates or changes to such data. Copyright 2004 Goldman, Sachs & Co. All Rights Reserved Review #04-3856

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