UNIVERSITY OF CALIFORNIA
Haas School of Business
Version (1.0 – 11/06/08) – subject to revision
Readings and Course Outline
Spring 2009
MFE230K – Dynamic Asset Management
Hayne Leland
Time, Site:
T TH 2:00 – 4:00 pm
Instructor:
Hayne Leland, Arno Rayner Professor of Finance
F688, Faculty Wing
(510) 642-8694 or (510) 841-8326
Leland@haas.berkeley.edu
Leland Office Hrs:
TH 10:30 – 12:00 am
TA
TBD
Readings:
Most readings available on Study.net (password required)
Course website on Catalyst; lectures will be posted there before class
Optional Text: J. Campbell and R. Viceira, Strategic Asset Allocation, Oxford, 2003
Readings with an asterisk (*) are optional, but provide interesting background and
formalisms for the results discussed in the lectures.
Fun background reading:
P. Bernstein, Capital Ideas: The Improbable Origins of Modern
Wall Street
N. Taleb, The Black Swan: The Impact of the Highly Improbable
N. Taleb, Fooled by Randomness: The Hidden Role of Chance in Life
and in the Markets
B. Schacter & R. Lindsey (eds.), How I Became A Quant: Insights
from 25 of Wall Street’s Elite
Grading:
Three homework assignments: 50%
Group Projects: 50%
Brief Description: The course examines principles of portfolio choice, recognizing that in the real
world, trading is costly, information is imperfect, and there may be substantial risks of extreme
events. We show how dynamic strategies, options, and other derivatives can be used to cater to
different investor risk appetites, time horizon, and hedging needs. How best to use superior
information, and how to implement dynamic strategies in a cost-efficient manner, are also
considered. Required coursework includes homework assignments and a major project, with topic(s)
to be assigned, that will be completed by groups of four or five students.
2
I. Introduction: Institutional Setting of Asset Management
A. Sources of Saving:
Individuals
Regular Accounts
Retirement Accounts and special tax treatments
Regular IRA
Roth IRA
Pension Funds
Defined Benefit vs. Defined Contribution (401(k)) Plans
Corporate vs. Individual Contributions
Tax Rules
ERISA and “Prudent Investor” Rule
PBGC
Insurance Companies
Foreign Sources
National investment funds
B. Asset Management: Institutional Investors
1. Mutual Funds: Investment Companies
Index Funds
Actively Managed Funds
Regulation: 1940 Act, enforced by SEC
Performance Evaluation (Morningstar)
2. Exchange-Traded Funds (ETFs)
3. “Alternative” Investment Funds
Hedge Funds
Private Equity
Real Estate
Venture Capital
Vulture Funds
4. Investment Advisors
Banks, Insurance Companies, Brokerage Firms
Consultants (e.g. Russell, Wilshire)
Background Sources
General/Banking/Insurance: http://www.financialservicefacts.org/
Mutual funds: http://www.ici.org/
Exchange Traded Funds: http://www.ici.org/aboutfunds/etf_faqs.htm
Hedge Funds: https://www.hedgefundresearch.com/hfrx_reg/index.php?fuse=login&1184097998
ERISA/PBGC: http://benefitslink.com/erisa/crossreference.html
3
2. Portfolio Choice in Static Models: Mean-Variance Analysis
a. Portfolio Choice in a Mean-Variance World: A Review
Assets and asset returns
Mean-Variance preferences
Rationales
Limitations
Portfolio Optimization
Two fund separation
The Sharpe ratio
Certainty equivalence
Portfolio constraints: short sales, etc.
Asset-Liability Management
CAPM equilibrium
The role of the market portfolio
Risk measures and return
Readings: Class Notes; Campbell & Viceira, Ch. 1 and Ch. 2 thru Section 2.1.1
S. Andrade handout on M-V frontier
P. Jorion, “The Long-Term Risks of Global Stock Markets,”
Journal of Portfolio Management, 2004.
F. Black, “Universal Hedging: Optimizing Currency Risk and Reward in
International Equity Portfolios,” Financial Analysts Journal 45,
1989, 16-22
c. Active Asset Management
Sources of alpha
Impounding “alpha” into portfolio choice
Benchmarks and Tracking Error
The “Information Ratio” and its uses
“Portable alpha” and market-neutral strategies
Tactical Asset Allocation
Readings: Class Notes
R. Fuller, “Behavioral Finance and the Sources of Alpha”, mimeo, 2000.
R. Litterman, “Hot Spots and Hedges,” Journal of Portfolio Management,
Dec. 1996, 52-75.
F. Black and R. Litterman, “Global Portfolio Optimization,” Financial
Analysts Journal 1992, 29-43.
C. Lee and B. Swaminathan, “Valuing the Dow: A Bottom-Up Approach,”
Association for Investment Management and Research (AIMR),
September/October 1999, 4-23.
D. Leinwebber, “Algo vs. Algo,” Institutional Investor’s Alpha, February 2007, 45-51.
*Garlappi, L., R. Uppal, and T. Wang, “Portfolio Selection with Parameter and Model
Uncertainty,” Review of Financial Studies 20, (January 2007), 41-81.
d. Performance Measurement and the CAPM
Alpha and the Sharpe Ratio
Performance attribution: Market timing vs. security selection
Style Analysis
Readings: Class Notes
W. Sharpe, “The Sharpe Ratio," Journal of Portfolio Management, Fall 1994, pp. 49-58.
4
W. Sharpe, “Assset Allocation: Management Style and Performance Measurement,”
Journal of Portfolio Management, Winter 1992, pp. 7-19.
R. Ibbotson and P. Kaplan, “Does Asset Allocation Policy Explain 40, 90, or 100 Percent
of Performance?” Financial Analysts Journal, Jan/Feb 2000, 26-33.
*R. Wermers, “Mutual Fund Performance: An Empirical Decomposition into StockPicking Talent, Style, Transactions Costs, and Expenses” Journal of Finance 55,
2000, 1655-95.
2. Portfolio Choice: A General Approach
a. A General Description of Uncertainty
States of nature
State-contingent claims
Complete markets
The (no) Arbitrage Principle
Readings: Class Notes
*Varian, H., “The Arbitrage Principle in Financial Markets”, Journal of Economic
Perspectives 1, 1987, pp. 55-72.
b. Expected Utility Theory
Measures of Risk Aversion
Optimal Portfolio Selection
Readings: Class Notes
Campbell & Viceira, remainder of Ch. 2
c. The Representative Investor and Asset Pricing
The Representative Investor: conditions for existence
Complete Markets
Incomplete Markets
The Representative Investor and state prices:
Pricing Implications of optimally holding the market portfolio
Special Cases: HARA, CAPM
Formulas for state prices
Readings: Class Notes
*Constantinides, G., “Intertemporal Asset Pricing with Heterogeneous Consumers
and Without Demand Aggregation,” Journal of Business, 55, 1982, pp. 253-267.
*Breeden, D., and R. Litzenberger, “Prices of contingent Claims Implicit in Option Prices,”
Journal of Business 51, 1978, 621-651.
d. Performance Measures: Beyond Mean-Variance
Theory
Hedge Fund Performance Measurement
Readings: Class Notes
Leland, H., “Beyond Mean–Variance: Performance Measurement in a
Nonsymmetrical World,” Financial Analysts Journal, Jan/Feb 1999.
Lo, Andrew W. “The Statistics of Sharpe Ratios,” Financial Analysts Journal,
July/August 2002, pp. 36-52.
5
*Goetzmann, W., Ingersoll, J., Spiegel, M., and Welch, I., “Portfolio Performance
Manipulation and Manipulation-Proof Performance Measures,” Review of Financial
Studies, October, 2007.
*G. Fama and K. French, “Value vs. Growth: The International Evidence,”
Journal of Finance 53, 1998,
*H. Kat and Hedge Fund replication in the New Yorker 2007:
http://www.newyorker.com/reporting/2007/07/02/070702fa_fact_cassidy#cont
3. Dynamic Portfolio Choice In Discrete and Continuous Time
a. Utility Maximization and Martingale Methods for Optimal Portfolio and Consumption Choice
Myopic vs. strategic behavior
Hedging the opportunity set
Readings: Class Notes
D. Breeden, “Optimal Dynamic Trading Strategies,” Economic Notes
by Monte dei Paschi di Siena 33, 2004, 55-81.
*R. Merton, “Optimum Consumption and Portfolio Rules in a
Continuous Time Model,” Journal of Economic Theory, 1971,
373-413.
b. General Characteristics of Optimal Strategies
Self-financing
Path Independence
Improving on path-dependent strategies
Readings:
Class Notes based on
*Cox, J. and Leland, H. “On Dynamic Investment Strategies,” Journal of
Economic Dynamics and Control, 2000, pp. .
*P. Dybvig, “Inefficient Dynamic Portfolio Strategies, or How to
Throw Away a Million Dollars in the Stock Market,” Review of
Financial Studies, 1988, pp. 67-88.
*Perold, A. and W. Sharpe, “Dynamic Strategies for Asset Allocation,”
Financial Analysts Journal 51, 1995, pp. 149-160.
c. Alternatives to Expected Utility Theory
Choosing from payoff functions
From payoffs to strategies—optimal portfolio choice
From strategies to payoffs—the inverse function
Readings: Class Notes
6
4. Long Run Strategic Asset Allocation
Campbell and Viceira, Chs. 3 – 6 (skim)
4. Active Management: Value vs. Momentum Strategies
Strategies providing convex vs. concave payoffs
Portfolio insurance and convexity of payoffs
Who Should Buy Portfolio Insurance? Who Should Sell?
Momentum vs. Value strategies
Some empirical evidence
Readings: Class Notes based on
*H. Leland., “Who Should Buy Portfolio Insurance?” Journal of
Finance, 1980.
*H. Leland, “Options and Expectations,” Journal of Portfolio
Management, December 1996
J. Laskonishok, N. Jegadeesh and L. Chan, "Momentum Strategies,"
Journal of Finance (1996).
**5.
Optimal Portfolio Choice with Transactions Costs
Readings:
** If time permits
Class Notes based on
* H. Leland, “Optimal Portfolio Implementation with Transactions Costs
and Capital Gains Taxes,” Working Paper, Haas School of Business,
University of California, Berkeley, September 2003.
Also,
* Davis, M., and Norman, A., “Portfolio Selection with Transactions
Costs,” Mathematics of Operations Research 15, 1990, pp. 676-713.
*Liu, H., “Optimal Consumption and Investment with Transaction Costs and
Multiple Risky Assets,” Journal of Finance 59, 2004, 289-338.
*Dammon, M., Spatt, C., and Zhang, H., “Optimal Asset Location and
Allocation with Taxable and Tax-Deferred Investing,” Journal of
Finance 59 (2004), pp. 999-1037.