Global Asset Allocation and Stock Selection


Campbell R. Harvey
Fuqua School of Business, Duke University, Durham, NC USA
National Bureau of Economic Research, Cambridge, MA USA

Spring Term 3, 2006

Course Description

This course delivers the theory and the quantitative tools that are necessary for global asset management. The focus of the course is on tactical rather than passive asset management. To this end, we develop the fundamental concepts of asset valuation in a world with time-varying risk and risk premiums. We also focus on the most recent advances quantitative forecasting methods.

The course builds on three asset allocation concepts. We begin with the strategic asset allocation decision. This is a long-term posturing. Next we discuss tactical asset allocation. This is short term changes in investment weights that capture targets of opportunities (sometimes called market timing). Finally, we focus on the bottom up decision. One unique feature of the course is that students are shown how to put a portfolio together from individual stocks (stock selection).

The Fuqua Honor Code is maintained in this course.

Students are expected to build some asset management software. This includes both strategic and tactical allocations. For Assignment 1, some students may choose to do a stock selection exercise. The most recent data are used in these real time allocations.

Prerequisites

Prerequisites are Finance 350 and at least one course in statistical analysis. A facility with matrix algebra, probability theory and statistics through linear regression is essential. Some differential calculus will be used. Students are not expected to be familiar with some of the advanced econometric techniques introduced in the course such as: generalized method of moments (GMM), generalized autoregressive conditional heteroskedasticity (GARCH), nonparametric density estimation, and entropy-based forecasting.

Problem Sets

The course material will be presented in lectures and problem sets. Five problem sets will are assigned during the semester. Groups of 5 people (or 4 if necessary) must be formed for the first four assignments. The ideal group includes of one person who has taken the statistical forecasting course, one person who knows some visual basic, and one person with some investment experience. The fifth assignment must be completed individually. As part of the Assignment 5, you must email me proportional contributions of the other group members (summing to 100%) for each of the assignments one through four - at the end of the semester. All problem sets will be graded. The first four problem sets should copied to the common network drive that I have set up.

The first assignment is required for all groups and is based on a stock selection exercise.

Assignment 1 will be posted to the Internet. My bank of assignments provides a resource which you, as students and graduates of my course, can use for a long time. Lecture notes have a tendancy to get out of date quickly. The Finance 453 homepage will be updated every time the course is taught. It is public domain so you can easily check in the future any new features in the course.

It is important that you start soon on assignment one.

In the second assignment, you will design your own quadratic optimization package using SOLVER in EXCEL. We will refer to this as strategic asset allocation. I assume that you have done a similar exercise in your statistics course. So the coding is very simple exercise. This program will take as inputs the expected returns, standard deviations and correlations for minimum of five and maximum of 12 asset classes in global equity markets. These markets can be countries (say, U.S., Japan, U.K., Germany, France, Mexico) or regions (say, U.S., Japan, Europe, other EAFE - Europe and Far East, Emerging Latin America, Emerging Asia , note the U.S. and Japan count as countries and regions!). You can use equities or bonds. The variance of the portfolio will be minimized for a target level of expected return. The program should also contain short-sale constraints and caps on the size of long positions. [This program must be clean enough that you would be proud to run it in front of a prospective employer.]

The third assignment involves forecasting monthly asset returns. Each student is in charge of an asset class. Data will be drawn down from on-line DATASTREAM (and from what I provide). Each student should be familiar with using DATASTREAM.

The fourth assignment uses introduces the currency data and draws implications for mean variance hedging.

The fifth assignment (which is completed individually) draws together all of the main concepts covered in the course.

Outside Class Contact

E-mail me at cam.harvey@duke.edu . If needed, call my assistant, Tara Bowens 660-7775 or email her at tbowens@mail.duke.edu, to set up an office visit. At odd hours, you can call me on my cellular at 919-271-8156 (if I am not available, I simply turn it off, so don't hesitate to call).

Video Clips

I have shot a series of short clips for both of my courses. NOTE: ALL VIDEO CLIPS ARE SERVED BY DUKE UNIVERSITY COMPUTERS.

Grading

The grading approach in the course will be based on performance on the assignments. Each assignment performance will be judged acceptable or not acceptable. There is no midterm or final exam. All students must turn in assignment 5. If you just turn in assignments 1, 2 and 5 (with acceptables), you will score "P". If you turn in assignments 1, 2, 3 and 5 (with acceptables), you will get "HP." If you turn in all five assignments (with acceptables), you will get "SP." This grading system basically allows you to select your grade in advance.

Please understand the selection of grades. I understand that some of you will not go into asset management but would like to take the course. There is nothing wrong with taking the 'P' or 'HP'. Indeed, this is exactly the reason why I designed the grading system this way. It is far better to do distinguished work on three assignments than average work on five assignments.

Copyrights

I reserve the copyright for all parts of the course. Any commerical reproduction of any course materials including lecture notes taken by students during the class is not allowed unless explicit permission is given by me.

Texts

There are no required texts in Finance 453. However, I recommend the following.

Harvey, Campbell R. 2005, Global Asset Allocation and Stock Selection [Some available on INTERNET. Goal is to have everything on internet by sometime in 2005.]

Campbell, John Y. and Luis Viceira, 2000, Strategic Asset Allocation, manuscript, View PDF.

Lee, Wai, 2000, Advanced Theory and Methodology of Tactical Asset Allocation John Wiley & Sons, New York, NY.

Grinold, Richard C. and Ronald N. Kahn, 2000, Active Portfolio Management: A Quantitative Approach to Providing Superior Returns and Controling Risk, Second Edition, McGraw Hill. (approx $70)

Alexander, Carol, 2001, Market Models: A Guide to Financial Data Analysis, Wiley. (approx $70)

Bernstein, William, 2001, The Intelligent Asset Allocator, McGraw Hill. (Great pre-read for the course)

Investment Analysis

This list is not comprehensive.
  • John Mauldin's Weekly Investment Letter. View here. Highly recommended.
  • Heckman Global Advisors. View here. Highly recommended.
  • Brad Delong's Semi-Daily Journal. View here. Highly recommended.

Outline and Recommended Reading Assignments

Most of the reading for Finance 453 will come from journal articles and working papers. In the past, the packet got out of control and cost $125. This year, there is no packet. Many of the articles are written by me. I have not included them in the pack because everything is available in PDF form on my web page. You will receive a CD which contains the most of the readings, some data, a complete history of my publications, and my hypertextual glossary.

Pre-class preparation

Familiarize yourself with my website. Read the following.
  • Research Protocol for Asset Allocation. [Required]. View HTML.
  • The Econometric Tools of Finance. [Required]. View HTML.

General background

  • VIDEO CONTENT
    • Short biography of instructor, Campbell R. Harvey View video. [6 minutes]
    • Course introduction View video. [6 minutes]

1. Thursday January 19 10:30ET

Course overview/Assignment #1 idea generation

The goal of this session is to set the expectations for the course. I will review each of the assignments and spend much of the class time detailing possible ideas for Assignment #1 which you need to start immediately on. We then talk about the U.S. business cycle and its impact on world asset allocation. The key concept will be the difference between unconditional expectations and conditional expectations. We will consider a single piece of conditioning information - the slope of the US term structure of interest rates.

2. Monday January 23, 10:30ET

Strategic Asset Allocation and Estimation Error

The focus is on the measurement of long-term expected returns, volatility and correlation. We will introduce the concept of tracking error. We will also examine survivorship bias. We will specifically address the question of what the expected performance of major markets will be over the next five to ten years. Be prepared to show at least one regression from your assignment 2, to the class which forecasts five year returns.

3. Thursday January 26, 10:30ET

Tactical Asset Allocation I: Predicting Returns

We will focus this lecture on the development of short-term forecasting models for asset returns. We will also talk about industry versus country allocation decisions.

  • Forecasting International Asset Returns [Required]. View HTML.

  • Risk identification regressions and prediction regressions. View HTML.

  • Local versus global variables in prediction regressions. View HTML.

  • ARTICLES
      • Deep C. Kapur and Paul Chanin, "Stock-Market Country Selection," Citigroup Equjity Research: Global View PDF.
      • Heckman Global Advisors. View here.
      • Campbell R. Harvey, "Time-Varying Conditional Covariances in Tests of Asset Pricing Models," Journal of Financial Economics 24 (1989): 289-317. (P3) View PDF, 2.4mb.
      • Campbell R. Harvey, "The World Price of Covariance Risk," Journal of Finance 46 (1991): 111-157. (P10) View PDF, 4.5mb.
      • Campbell R. Harvey, "The Risk and Predictability of International Equity Returns," with Wayne Ferson, Review of Financial Studies 6 (1993) 527- 566. (P21) View PDF, 4.1mb.
      • Campbell R. Harvey, "Predictable Risk and Returns in Emerging Markets," Review of Financial Studies (1995): 773-816. (P32) View PDF, 3.4mb..
      • Stefano Cavalaglia and Vadim Moroz "Cross-Industry, Cross-Country Allocation" Financial Analysts Journal November/December 2002. View PDF.
      • Stefano Cavalaglia, D. Cho and Brian Singer, "Further evidence on global pricing." View PDF.
      • Stefano Cavalaglia, C. Brightman, and M. Aked, "On the increasing importance of industry factors: Implications for global portfolio management." View PDF.

    • VIDEO CONTENT
      • Building short-term tactical asset return forecasting models. View video. [3 minutes]
      • The usefulness of R-square in evaluating prediction models. View video. [4 minutes]
      • Macroeconomic vs. financial variables in asset return forecasting models. View video. [3 minutes]
      • Unconditional vs. conditional expected asset returns. View video. [4 minutes]

    • ASSIGNMENT
      • One page from Assignment 2 is due. The page must describe the best regression model for forecasting 5-yr S&P 500 returns. I will likely put the page on the overhead so it needs to be readable.

    4. Monday January 30, 10:30ET

    Tactical Asset Allocation II: Comovement, Volatility, Skewness

    This lecture explores the econometric techniques used for modeling volatilities and correlations. GARCH models will be explored along with alternatives such as ones based on exponentially weighted moving averages.

    Guest. Professor Tim Bollerslev, founder of GARCH

    • Approaches to Asset Management [Required]. View HTML,

    • Program to Estimates a GARCH(1,1) Model (Excel).

    • Higher Moments in Asset Pricing (Powerpoint). [Required]

    • AlternativeSoft Higher Moment Optimizer (30-day Trial).

    • ARTICLES
      • Campbell R. Harvey, "Forecasting International Equity Correlations," with Claude Erb and Tadas Viskanta, Financial Analysts Journal (1994): November/December 32-45. (P27) View PDF.[Required]
      • Campbell R. Harvey, "Do World Markets Still Serve as a Hedge?," with Claude Erb and Tadas Viskanta, Journal of Investing (1995): Fall 23-46. (P28) View PDF.
      • Campbell R. Harvey, "The Cross-Section of Volatility and Autocorrelation in Emerging Markets" Finanzmarkt und Portfolio Management 9 (1995): 12-34. (P29) View PDF.
      • Campbell R. Harvey, "Predictable Risk and Returns in Emerging Markets," Review of Financial Studies (1995): 773-816. (P32) View PDF.
      • Campbell R. Harvey, "Emerging Equity Market Volatility," with Geert Bekaert, Journal of Financial Economics (1997): 43:1, January, 29-78. (P40) [prev. W14] View PDF.
      • Campbell R. Harvey,"Autoregressive Conditional Skewness," with Akhtar Siddique, Journal of Financial and Quantitative Analysis 1999, View PDF.
      • Campbell R. Harvey, "Conditional Skewness in Asset Pricing Tests," with Akhtar Siddique, Journal of Finance 2000, View PDF.
      • Campbell R. Harvey, "The Cross-Section of Expected Risk Exposure," with Akhtar Siddique, Working paper View PDF.
      • Campbell R. Harvey, "Portfolio Selection with Higher Moments" with Merrill Liechty, John Liechty and Peter Muller, View PDF.
      • Con Keating and William F. Shadwick, 2002, "An Introduction to Omega" View PDF.
      • Con Keating and William F. Shadwick, May 2002, "A Universal Performance Measure" View PDF.
      • Con Keating and William F. Shadwick, "Asset Optimisation" View PDF.
      • A. Cascon, Con Keating and William F. Shadwick, March 2003, "The Omega Function" View PDF.
      • Hossein Kazemi, Thomas Schneeweis, and Raj Gupta, June 2003, "Omega as a Performance Measure", View PDF.
      • EDHEC Risk and Asset Management Research Centre, 2004, "Fund of Hedge Fund Reporting: A Return-Based Approach to Fund of Hedge Fund Reporting", View PDF.
      • Andrew Frankel, 2003, "A Program" (Excel).

    • VIDEO CONTENT
      • Unconditional vs. conditional volatility. View video. [6 minutes]
      • The specification of dynamic risk functions. View video. [8 minutes]
      • Skewness movie produced by a Fuqua 1998 graduate. View video.
      • Skewness and asset management. View video. [8 minutes]

    5. Thursday February 2, 10:30ET

    Asset Pricing and Asset Allocation

    This lecture reviews the state of asset pricing theory, from the simple CAPM to multifactor models, in international finance. Emphasis is placed on identifying and dymamically modeling risk. We start with average or unconditional exposure and work our way to more dynamic, time-varying models.

    • Predictive vs. Explanatory Models (Powerpoint). [Required].

    • ARTICLES
      • Campbell R. Harvey, "Sources of Risk and Expected Returns in Global Equity Markets," with Wayne Ferson, Journal of Banking and Finance (1994): 775-803. View PDF. [Required]
      • Campbell R. Harvey, "The Risk Exposure of Emerging Equity Markets," World Bank Economic Review (1995): 19-50. View PDF.
      • Campbell R. Harvey, "The Risk and Predictability of International Equity Returns," with Wayne Ferson, Review of Financial Studies 6 (1993) 527- 566. View PDF.
      • Campbell R. Harvey, "An Exploratory Investigation of the Fundamental Determinants of National Equity Market Returns," with Wayne Ferson, in Jeffrey Frankel, Editor, The Internationalization of Equity Markets, (Chicago: University of Chicago Press, 1994, pp. 59-138). View PDF.
      • Eugene F. Fama and Kenneth R. French, 1992, "The Cross-Section of Expected Stock Returns" Journal of Finance 47, 427-465. View PDF.
      • Eugene F. Fama and Kenneth R. French, 1993, "Common Risk Factors in the Returns on Stocks and Bonds," Journal of Financial Economics 33, 3-56. View PDF.
      • Eugene F. Fama and Kenneth R. French, 1998, "Value versus growth: The international evidence" Journal of Finance View PDF.[Required]
      • Campbell R. Harvey, "Conditioning Variables and the Cross-Section of Stock Returns," with Wayne Ferson, Journal of Finance 1999, 54 1325-1360. View PDF. [Required]

    • VIDEO CONTENT
      • Is the world CAPM dead? View video. [8 minutes]
      • Is the variance of a well diversified portfolio the "risk"? View video. [8 minutes]
      • Possible world risk factors. View video. [8 minutes]
      • Risk models and predictive models in trading strategies. View video. [8 minutes]

    • ASSIGNMENT
      • Assignment 2 is due.

    6. Monday February 6, 10:30ET

    Attributes and Asset Pricing

    A number of recent research papers have examined the role of attributes and expected returns. In this lecture we develop a framework to link these attributes to expected returns.

    • Optimal Adjustment of Attributes (Powerpoint). [Required].

    • ARTICLES
      • Campbell R. Harvey, "Fundamental Determinants of International Equity Returns: A Perspective on Conditional Asset Pricing," with Wayne Ferson, Journal of Banking and Finance (1997): 21, 1625-1665. (P42)[prev. W7] View PDF. [Required]
      • Kent Daniel and Sheridan Titman, 1997, "Evidence on the Characteristics of Cross-Sectional Variation in Stock Returns" Journal of Finance 52, 1-33. View PDF. [Required]
      • Eugene F. Fama and Kenneth R. French, 1992, "The Cross-Section of Expected Stock Returns" Journal of Finance 47, 427-465. View PDF.
      • Eugene F. Fama and Kenneth R. French, 1998, "Value versus growth: The international evidence" Journal of Finance View PDF.
      • Campbell R. Harvey,"Conditioning Variables and the Cross-Section of Stock Returns," with Wayne Ferson, Journal of Finance 1999, 54 1325-1360. (P57) [prev. W32] View PDF.

    • VIDEO CONTENT

    7. Thursday February 9, 10:30ET

    Managing Geopolitical Risk In Investment Decision Making

    Now that we have some familiarity with the tools of asset allocation and risk analysis, we now explore the business strategy of asset management. The class will be divided into the core groups at the fictional firm. Be ultra prepared.

    8. Monday February 13 10:30ET

    Commodities as an Asset Class

    Traditional asset management focuses on equities and fixed income. In this lecture, we explore the role of commodities in asset allocation. We examine the strategic and tactical value of commodity futures.

    9. Thursday February 16, 10:30ET

    Stock Selection I: Screening Programs

    This lecture describes the state of the art techniques for selecting equity securities using multivariate scoring techniques.

    • Quantitative Stock Selection (Powerpoint). [Required].

    • ARTICLES
      • Campbell R. Harvey, "Stock Selection in Emerging Markets: Portfolio Strategies for Malaysia, Mexico and South Africa" with Dana Achour, Greg Hopkins and Clive Lang, Emerging Markets Quarterly 1999, Winter, 38-91. View PDF.
      • Campbell R. Harvey, "Stock Selection in Malaysia" with Dana Achour, Greg Hopkins and Clive Lang, Emerging Markets Quarterly 1999, Spring, 54-91 View PDF.
      • Campbell R. Harvey, "Stock Selection in Mexico" with Dana Achour, Greg Hopkins and Clive Lang, Emerging Markets Quarterly 3, Fall 1999, 38-75. View PDF.
      • Campbell R. Harvey, "Firm Characteristics and Investment Strategies in Africa: The Case of South Africa" with Dana Achour, Greg Hopkins and Clive Lang, African Finance Journal 1, 1999, 1-68. View PDF of last working paper version.
      • Jaap van der Hart, Erica Slagter and Dick van Dijk, "Stock Selection Strategies in Emerging Markets", Journal of Empirical Finance 2003. View PDF.
      • Geert Rouwenhorst, "Local return factors and turnover in emerging stock markets", Journal of Finance 54, 1439-1464. View PDF.
      • Geert Rouwenhorst, "International Momentum Strategies" Journal of Finance 53, 1998, 267-284. View PDF.
      • Utpal Bhattacharya and Hazem Daouk, "The World Price of Insider Trading" View PDF.

    • VIDEO CONTENT
      • Stock selection and spread portfolio construction View video. [8 minutes]
      • Stock selection and market efficiency. View video. [5 minutes]

    10. Monday February 20, 10:30ET

    Stock Selection II: Regression Based Selection

    We introduce regression type models to select stocks. We link these regressions to asset pricing theory and interpret the evidence that fundamental factors are able to identify good and bad expected returns opportunities.

    • Quantitative Stock Selection (Powerpoint). [Required].

    • ARTICLES
      • Campbell R. Harvey, "Fundamental Determinants of International Equity Returns: A Perspective on Conditional Asset Pricing," with Wayne Ferson, Journal of Banking and Finance (1997): 21, 1625-1665. View PDF.

      • VIDEO CONTENT
        • Firm specific attribute adjustment in cross-sectional screening. View video. [5 minutes]
        • Sorting versus regression. View video. [5 minutes]
        • Multivariate attribute strategies and developing scoring screens. View video. [5 minutes]

      • ASSIGNMENT
        • Assignment 4 is due.

    11. Thursday February 23, 10:30ET

    International Hedge Funds

    The goal of this lecture is to introduce and to explain the growth in international hedge funds. We will also discuss high frequency trading strategies.

    • ARTICLES
      • Campbell R. Harvey, "Forecasting Foreign Exchange Market Returns via Entropy Based Coding: The Framework," with Arman Glodjo. View PDF.

    • VIDEO CONTENT

    12. Monday February 27, 10:30ET

    Presentations

    Each group will have 15 minutes to present the results of their Assignment 1 projects.

  • ASSIGNMENT
    • Assignment 5 will be on-line after class. It is due the next day at 6pm.

    Supplementary Materials

    Black-Litterman

    Fischer Black and Robert Litterman, 1991, Global Asset Allocation with Equities, Bonds and Currencies, Goldman Sachs, Fixed Income Research.

    Fischer Black and Robert Litterman, 1992, Global Portfolio Optimization, Financial Analysts Journal.

    Thomas M. Idzorek, A step-by-step guide to the Black-Litterman model

    Thomas M. Idzorek, 2002, Portfolio Optimizer Overview.

    Thomas M. Idzorek, 2004, Black-Litterman.

    Thomas M. Idzorek and Jill Adrogue, September, 2003, Black-Litterman Return Forecasts in Zephyr Allocation Advisor.

    Goldman Sachs, 1999, Importance of Asset Allocation in Managing Private Equity Commitments.

    Robert Litterman and Kurt Winkelmann, Goldman Sachs, January 1996, Managing Market Exposure.

    Andrew Bevan and Kurt Winkelmann, Goldman Sachs, June 1998, Using the Black-Litterman Global Asset Allocation Model: Three Years of Practical Experience.

    Guangliang He and Robert Litterman, Goldman Sachs, December 1999, The Intuition Behind the Black-Litterman Model Portfolios.

    Werner Koch, April 2005,, Consistent Asset Return Estimates: The Black-Litterman Approach.

    Estimation

    CSFB, Alpha pains

    Robert Litterman and Kurt Winkelmann, Goldman Sachs, January 1998, Estimating Covariance Matrices.

    Alpha

    Thomas, Lee R., Engineering an Alpha Engine

    Robert Litterman, Goldman Sachs, 2004, Active risk puzzle.

    Till, Hilary, On the role of hedge funds in institutional portfolios

    Cavaglia, Stefano and Vadim Moroz, Cross-industry, cross-country allocation

    Abacus Analytics, September 2003, Equity Factors and Portfolio Management: Alpha Generation Versus Risk Control.

    Hillary Till, September 2003, Risk Measurement of Investments in the Satellite Ring of a Core-Satellite Portfolio: Traditional versus Alternative Approaches.

    Crestmont Research, PE Heat Map.

    Selection

    Strongin, Steven, A stockpicker's reality: Part III

    Strongin, Steven, A stockpicker's reality: Part II, Beating benchmarks

    Bhorjraj, Sanjeev, Charles M.C. Lee, and David T. Ng, International valuation using smart multiples

    Miscellaneous

    Asness, Cliff, Bubble logic at five years old

    French, Craig, The Treynor Capital Asset Pricing Model

    Various authors, June 2003, Dating of Europe's Recessions.

    R. McFall Lamm, Jr., Fall 2003, Asymmetric Returns and Optimal Hedge Fund Portfolios.

    Transactions Costs

    Richard C. Grinold and Mark Stuckelman, 1993, The Value-Added/Turnover Frontier, Journal of Portfolio Management. View PDF.

    Bruce M. Collins and Frank J. Fabozzi, 1991, A Methodology for Measuring Transactions Costs, Financial Analysts Journal. View PDF.

    David Leinweber, 2002, Using Information from Trading in Trading and Portfolio Management: Ten Years Later, View PDF.

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