Portfolio Construction and Evaluation

1© 2014 Windham Capital Management, LLC
1
Portfolio Construction and Evaluation
Jonathan Kazarian
Windham Client Consultant
3/27/2014

Goal:
Generate an efficient portfolio
which satisfies our client’s
needs.

Hypothetical Client
One million in
investable
assets
Requests
global
diversification
but maintains
a home bias
Concerned
about losses,
particularly of
15% or more
Goal: double
value over 12
years

Agenda
1. Discuss the asset allocation process
2. Develop Capital Market Forecasts
3. Construct a Mean Variance efficient
portfolio
4. Evaluate portfolios using exposure to loss
and potential wealth analytics

Asset Allocation
■ Identify eligible asset classes
■ Estimate return, risk and correlations
■ Generate efficient portfolios
■ Select portfolios that match our tolerance
for risk

Eligible Asset Classes
■ Improve portfolio efficiency by raising return or
lowering risk
■ Independent of other asset classes
■ Constituents of an asset class must be relatively
similar
■ Have the capitalization capacity to absorb a
meaningful fraction of our portfolio
Mark Kritzman, “Toward Defining an Asset Class”, Journal of Alternative Investments, Summer 1999

Capital Market Forecasting
“The process of selecting a portfolio may be divided into
two stages. The first stage starts with observation
and experience and ends with beliefs about the
future performance of available securities. The
second stage starts with relevant beliefs about future
performances and ends with choice of portfolio. This
paper is concerned with the second stage.”
Harry Markowitz, “Portfolio Selection,” Journal of Finance, March 1952

Standard Deviation
Not static throughout time
Chow, G., Jacquier, E., Kritzman, M., and Lowry, K., Optimal Portfolios in Good Times and Bad, Financial Analysts Journal, May/June 1999
Asset Class Full Sample Turbulent
Large Cap Stock 16.53% 23.56%
Small Cap Stocks 21.34% 29.51%
Foreign Stocks 18.78% 24.05%
Commodities 22.63% 30.62%
Real Estate 21.88% 35.82%
US Bonds 4.01% 6.20%
Cash 0.72% 0.86%
Data from 02/1989 - 02/2014, Turbulence Threshold at 20%
• The table above shows standard deviation estimates for both normal and
turbulent regimes
• Volatility rises during times of turbulence

Correlations
Chow, G., Jacquier, E., Kritzman, M., and Lowry, K., Optimal Portfolios in Good Times and Bad, Financial Analysts Journal, May/June 1999
Full Sample Large Cap Stock Small Cap Stocks Foreign Stocks Commodities Real Estate US Bonds
Small Cap Stocks 0.84
Foreign Stocks 0.74 0.65
Commodities 0.18 0.20 0.24
Real Estate 0.55 0.63 0.48 0.14
US Bonds 0.12 0.00 0.09 -0.02 0.14
Cash 0.03 -0.04 -0.05 0.06 -0.07 0.16
Turbulence Large Cap Stock Small Cap Stocks Foreign Stocks Commodities Real Estate US Bonds
Small Cap Stocks 0.83
Foreign Stocks 0.76 0.66
Commodities 0.28 0.33 0.23
Real Estate 0.64 0.71 0.54 0.25
US Bonds 0.27 0.18 0.23 -0.04 0.23
Cash 0.23 0.15 0.08 0.25 0.15 0.24

Returns
Asset Class Historical Equilibrium (Beta) View (Confidence) Blend
Large Cap Stock 11.40% 8.08% (1.16) N/A 8.08%
Small Cap Stocks 12.08% 8.68% (1.33) 10% (50%) 9.34%
Foreign Stocks 6.92% 9.85% (1.66) N/A 9.85%
Commodities 7.60% 7.72% (1.06) 5% (50%) 6.35%
Real Estate 11.67% 8.26% (1.21) N/A 8.26%
US Bonds 6.90% 4.47% (0.14) N/A 4.47%
Cash 3.46% 4% (0) 1% (75%) 1.74%
• We use Equilibrium Returns blended with views for specific asset classes
• We estimate the market’s expected return equal to 7.5% and the risk-free
return equal to 4.00%

Mean Variance Optimization
“The process of selecting a portfolio may be divided
into two stages. The first stage starts with observation
and experience and ends with beliefs about the future
performance of available securities. The second
stage starts with relevant beliefs about future
performances and ends with choice of portfolio.
This paper is concerned with the second stage.”
Harry Markowitz, “Portfolio Selection,” Journal of Finance, March 1952

Optimal Portfolios
Asset Class Conservative Moderate Aggressive
Large Cap Stock 15.15% 19.19% 12.35%
Small Cap Stocks 5.58% 8.21% 27.95%
Foreign Stocks 17.28% 22.83% 33.58%
Commodities 8.20% 9.81% 4.62%
Real Estate 4.03% 4.96% 0.89%
US Bonds 35.00% 35.00% 20.61%
Cash 14.76% 0.00% 0.00%
Return 6.12% 7.16% 8.20%
Risk 7.81% 10.07% 13.45%
• The return and risk are derived using Equilibrium returns adjusted
for our views and historical standard deviations and correlations

Portfolio Selection
■ Theoretical Approach: Risk Aversion
►“How many units of returns you are willing to give up
in order to decrease risk by one unit”
■ In Practice:
►Exposure to Loss
Probability of Loss
Value at Risk
►Future Wealth
“What’s your number?
http://www.adrants.com/

Exposure to Loss
■We can estimate the likelihood that a portfolio with a particular
expected return and standard deviation will experience a certain
loss over a particular horizon.
►Probability of Loss
■Alternatively, we can easily estimate the largest loss a portfolio
might experience given a certain level of confidence.
►Value-at-Risk
■For normal periods, risk parameters are based on the entire
sample of returns
■For the turbulent regime, risk parameters are based on the
turbulent sub-sample of returns

Exposure to Loss (Within Horizon)
■ Investors typically measure exposure to loss at the end of their investment
horizon
►This ignores what may happen along the way; this is a dangerous oversight
■ Within Horizon risk provides a more realistic risk assessment
Probability of
a 10% Loss
at the End of
the Horizon
is 20%
Probability of
a 10% Loss
Within the
Horizon is
80%
Kritzman, M. and Risk, D., The Mismeasurement of Risk, Financial Analysts Journal, May/June 2002

Exposure to Loss (Probability of Loss)
• Likelihood of losses increases during Turbulent periods
• The current portfolio has less than a 1% chance of losing 15% or more at
the end of 15 years
• But there is over an 18% chance that the portfolio will depreciate by
similar amounts along the way
• This increases to nearly 47% in turbulent periods

Exposure to Loss (Value-at-Risk)
• Again, we can observe drastic differences in value at risk
• The worst outcome for a moderate investor given a 1% probability in
normal periods is an increase in value of $22,000
• In comparison, the worst outcome in the interim period is a decline of at
least $266,668
• When in periods of turbulence, the worst outcome increases to $383,329

Wealth Analysis (Monte-Carlo Simulation)
Procedure:
1. Randomly generate 2000 different asset return histories using our
estimated return, risk and correlation. Each history is 20 years in length
2. For each month, calculate the portfolio return
3. Compound the portfolio wealth by this return

Additional Evaluation Measures
■ Factor Analysis
►Identify and measure common sources of risk and return for managers,
asset classes, and portfolios
►Go beyond asset allocation to identify the underlying exposures to
specific sources of risk
■ Risk Budgets and Value at Risk Sensitivity
►Evaluate the risk of each asset class in isolation
►How does changing our allocation impact our portfolio’s risk?
■ Stress Testing & Scenario Analysis
►Estimate potential economic loses in unfavorable markets
►Examine portfolio-specific weakness
Ex. how sensitive are our portfolios to interest rate shocks?
■ Wealth Analysis incorporating Cash Flows
►Use simulation to analyze how cash flows will impact future wealth for
different portfolios

Proposed Portfolio: Moderate
Asset Class Moderate
Large Cap Stock 19.19%
Small Cap Stocks 8.21%
Foreign Stocks 22.83%
Commodities 9.81%
Real Estate 4.96%
US Bonds 35.00%
Cash 0.00%
Return 7.16%
Risk 10.07%
Probability of 15% Loss
at the End of a 12 year
Horizon
Probability of 15% Loss
Within Horizon 12 year
Horizon
Value at Risk at the 1%
Level at the End of a 12
year Horizon
Value at Risk at the 1%
Level Within the 12 year
Horizon
Median Wealth Potential
in 12 years
0.19% 9.05% -$21,874 $266,668 $2,179,778

Thank You
Webinar: Windham Software Overview
April 2nd at 11:00AM EDT
Webinar: Measuring Potential Investment
Outcomes Using Simulation
April 16th at 10:00AM & 2:00PM EDT
Register online at www.windhamgs.com/news
Questions and feedback:
info@windhamgs.com

Disclaimer
The information contained in this presentation (the “Presentation”) is prepared solely for informational purposes. The Presentation is neither an offer to buy or
sell nor a solicitation of an offer to buy or sell any security, or interests or shares in any fund or strategy. Historical data and other information contained
herein is believed to be reliable but no representation is made as to its accuracy or completeness or suitability for any specific purpose. Past performance is
not indicative of future performance, which may vary. There can be no assurance that the strategies’ investment objectives will be achieved. All strategies in
this Presentation place investor capital at risk. Future returns are not guaranteed and a loss of principal may occur.
References to market or composite indices, benchmarks or other measures of relative market performance over a specified period of time are provided for
your information only. Reference to an index does not imply that the Windham portfolio will achieve returns, volatility or other results similar to the index. The
composition of a benchmark index may not reflect the manner in which a Windham portfolio is constructed in relation to expected or achieved returns,
investment holdings, portfolio guidelines, correlations or tracking error targets, all of which are subject to change over time.
Prospective investors should not rely on this Presentation in making any investment decisions. Windham’s portfolio risk management includes a process for
managing and monitoring risk, but should not be confused with, and does not imply, low risk. Asset classes and proportional weightings in Windham portfolios
may change at any time without notice. Windham does not provide tax advice to its clients and all investors are urged to consult with their tax advisors with
respect to any potential investment.
Please refer to Windham’s ADV Part 2A for additional information. Windham and its owners disclaim any and all liability relating to this Presentation, including
without limitation any express or implied representations or warranties for statements contained in, and omissions from, this information.

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