9781118115060

Through a series of articles spanning over 15 years of research, Paul D. Kaplan, who developed the methodologies behind the Morningstar Rating and the Morningstar Style Box tackles the issues investors face when they attempt to put the concepts of asset allocation into practice, among them: How should the asset classes be defined? Should equities be divided into asset classes based on investment style, geography, or other factors? Should asset classes be represented by market-cap-weighted indexes or should other principles, such as fundamental weights, be used? How do actively managed funds fit into asset-class mixes? Kaplan also interviews the intellectuals who have greatly influenced the evolution of asset allocation, including Harry Markowitz, Roger Ibbotson, and the late Benoit Mandelbrot. Throughout the book, Kaplan offers his own opinions and analysis. He includes three appendices that put theory into action with technical details for new asset-allocation frameworks, including the next generation of portfolio construction, which Kaplan dubs "Markowitz 2.0."

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Paul D. Kaplan is quantitative research director at Morningstar Europe and is responsible for the quantitative methodologies behind Morningstar's fund analysis, indexes, advisor tools, and other services. Dr. Kaplan conducts research on investment style analysis, performance and risk measurement, asset allocation, retirement-income planning, portfolio construction, index methodologies, and alternative investments. He led the development of quantitative methodologies behind the Morningstar Rating for funds (Morningstar's star rating), the Morningstar Style Box, and the Morningstar family of indexes. Many of Dr. Kaplan's research papers have been published in professional books and publications such as the Financial Analysts Journal, the Journal of Portfolio Management, the Journal of Wealth Management, the Journal of Investing, the Journal of Performance Measurement, the Journal of Indexes, and the Handbook of Equity Style Management. He received the 2008 Graham and Dodd Award and won a Graham and Dodd Award of Excellence in 2000.

Foreword xi

Introduction xxiii

A Note on Expected Return and Geometric Mean xxv

Acknowledgments xxxi

PART ONE Equities

CHAPTER 1 Purity of Purpose: How Style-Pure Indexes Provide Useful Insights 7

CHAPTER 2 Investing in Europe with Style: Why Investors in Europe Would Benefit From Constructing Portfolios Through the Prism of Style 15

CHAPTER 3 Why Fundamental Indexation Might—or Might Not—Work 21

CHAPTER 4 The Fundamental Debate: Two Experts Square Off on the Big Issues Surrounding Fundamentally Weighted Indexes 39

CHAPTER 5 Collared Weighting: A Hybrid Approach to Indexing 51

CHAPTER 6 Yield to Investors? A Practical Approach to Building Dividend Indexes 63

CHAPTER 7 Holdings-Based and Returns-Based Style Models 71

CHAPTER 8 Estimates of Small Stock Betas Are Much Too Low 103

CHAPTER 9 A Macroeconomic Model of the Equity Risk Premium 117

PART TWO Fixed Income, Real Estate, and Alternatives

CHAPTER 10 Good and Bad Monetary Economics, and Why Investors Need to Know the Difference 133

CHAPTER 11 Inflation, Gilt Yields, and Economic Policy 143

CHAPTER 12 Reverse Mean-Variance Optimization for Real Estate Asset-Allocation Parameters 147

CHAPTER 13 The Long and Short of Commodity Indexes 157

CHAPTER 14 Less Alpha and More Beta Than Meets the Eye 175

CHAPTER 15 Venture Capital and its Role in Strategic Asset Allocation 179

PART THREE Crashes and Fat Tails

CHAPTER 16 One-and-a-Quarter Centuries of Stock Market Drawdowns 193

CHAPTER 17 Stock Market Bubbles and Crashes: A Global Historical and Economic Perspective 199

CHAPTER 18 De´ ja` Vu All Over Again 211

CHAPTER 19 De´ ja` Vu Around the World 223

CHAPTER 20 Getting a Read on Risk: A Discussion with Roger Ibbotson, George Cooper, and Benoˆıt Mandelbrot on the Crisis and Risk Models 239

PART FOUR Doing Asset Allocation

CHAPTER 21 Does Asset-Allocation Policy Explain 40 Percent, 90 Percent, or 100 Percent of Performance? 253

CHAPTER 22 Asset-Allocation Models Using the Markowitz Approach 267

CHAPTER 23 Asset Allocation with Annuities for Retirement Income Management 275

CHAPTER 24 MPT Put Through the Wringer: A Debate Between Steven Fox and Michael Falk 303

CHAPTER 25 Updating Monte Carlo Simulation for the Twenty-First Century 311

CHAPTER 26 Markowitz 2.0 325

CHAPTER 27 What Does Harry Markowitz Think? A Discussion with Harry Markowitz and Sam Savage 351

Afterword 367

About the Author 375

Index 377

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Frontiers of Modern Asset Allocation

Frontiers of Modern Asset Allocation

1118115066

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