Amundi Working Paper

WP-032-2012

November 2012

Unexpected Returns.
Methodological Considerations on Expected Returns in Uncertainty
Sylvie de Laguiche, Head of Quantitative Research - Amundi
Gianni Pola, Balanced Quantitative Research - Amundi
Photo credit : Frank Hülsbömer

For professional investors only

 Unexpected Returns.
Methodological Considerations on Expected Returns in Uncertainty

Sylvie de Laguiche
Head of Quantitative Research - Amundi
sylvie.delaguiche@amundi.com

Gianni Pola
Balanced Quantitative Research - Amundi
gianni.pola@amundi.com

1
About the authors

Sylvie de Laguiche, Head of Quantitative Research - Amundi

Sylvie de Laguiche has been heading the quantitative research team
at Amundi (previously Credit Agricole Asset Management) since
2005. Prior to that, she started her professional career as a
consultant at Associés en Finance in Paris. She then served as a
quantitative analyst at Indosuez Asset Management between 1991
and 1997 and was then appointed Head of the fixed income and
asset allocation quantitative research team at Credit Agricole Asset
Management in 1997.
Sylvie de Laguiche holds a PhD in Mathematics and Finance from
Paris Dauphine University. She was a student at the Ecole Normale
Supérieure in Paris. She has given some lectures at Paris Dauphine
University and HEC and is a board member of Inquire Europe. She
is the author of several papers on fixed income and quantitative
research.

Gianni Pola, PhD, Balanced Quantitative Research - Amundi

Gianni Pola joined Amundi SGR (previously Credit Agricole Asset
Management SGR) in 2005 and the Balanced Quantitative Research
team in June 2012 as a quantitative analyst. He started his
professional career in 2005 as quantitative analyst at Nextra
Investment Management (Banca Intesa, Milan). Previously, he
collaborated with the Universities of Manchester UMIST (UK),
Newcastle upon Tyne (UK), and L’Aquila (Italy) on research topics
related to neural coding, econophysics, and robust optimization. He
currently lectures in Quantitative Finance at the School of
Management MIP at the Milan Polytechnic (since 2011).
He holds a PhD in Computational Neuroscience (2004) from the
University of Newcastle upon Tyne and a first class honours degree
in Theoretical Physics (2000) from the University of L’Aquila
(Italy). In 2000 he was INFN (National Institute for Nuclear
Physics) fellow at LNGS (National Laboratory at Gran Sasso,
Italy). He has written several articles on peer review journals, book
chapters, conference proceedings and working papers on portfolio
construction, diversification, optimal dynamic asset allocation,
expected returns, computational models for time-series analysis,
neuronal coding and computational neuroscience.

2
 Main ideas

• The recent crisis has brought increasing uncertainty in the exercise of forecasting long-
term returns due to:

- significant changes in risk levels and observed risk premia which make calibration
on recent history more difficult;

- unpredictable effects of non-conventional monetary policies on macro-economic

variables, especially inflation;

- the fact that some market variables (interest rates) are in uncharted territory.

• For strategic allocation of diversified portfolios, despite these major changes, the
traditional Sharpe ratio approach, equal for all asset classes, may still be of interest
because it provides good risk diversification.

• As for establishing a forward looking expected return which can serve as a reference for
discounting liabilities, a more careful approach would be required. It would have to take
into account the observed dependency on macro-economic scenarios and the distortion in
favour of less risky or less liquid assets which has been observed and documented in
literature.

• Complementary approaches, mixing skills in macroeconomics, econometrics and

quantitative finance may be required now in order to overcome the challenge.

3
0. Introduction

Expected returns are closely related to the portfolio allocation: according to the Markowitz
portfolio selection (1952), once agreed on the market risk model and the investor’s risk
aversion, expected returns unambiguously determine the portfolio, and, conversely, reverse
optimisation techniques (Cantaluppi; 1999) allow us to relate a given (optimal) portfolio to a
set of expected returns. While the finance industry and academia are aware of the inadequacy
of the Markowitz model, it is clear that estimation of expected returns is a key issue for
strategic asset allocation. A pension fund, for example, needs expected returns on asset
classes for:

• building a strategic allocation; and

• assessing returns on assets and setting an appropriate discount rate for liabilities.

While in the former, risk-adjusted hierarchy between assets is more relevant, in the latter the
level of returns itself is crucial to determine discount rates. In this document, we refer to long
horizons - at least ten years - somewhat in line with the average liabilities in pension funds.

Unfortunately, while volatility is somewhat predictable as "large changes tend to be followed

by large changes, of either sign, and small changes tend to be followed by small changes"
(Mandelbrot, 1963), returns are un-correlated over time and probably unobservable 1. This is
particularly true today: the recent crisis in the Eurozone and the previous sub-prime crisis in
2008, remind us that returns dynamics are not stationary in time, and that prevailing market
conditions can strongly affect returns and cause them to deviate significantly from the long-
term average.

Many financial variables are in a peculiar territory, never reached going back to many
decades, and more than a century in some cases:

• the 10-year US Treasury yield is at its lowest level since 1871 (see chart 1);

• the two-year yield synchronously negative in many countries in 2012 (Germany,

Netherlands, Switzerland, Denmark; see chart 2, left panel); and

• the decoupling of the Eurozone: the two-year yield divergence (see chart 2, right
panel).

1 Historical averages are good estimators if and only if the (underlying) stochastic process is stationary. Rapidly changing regimes and non-stationary dynamics prevent us
from estimating returns from historical averages, making them effectively unobservable.

4
Chart 1

10-year US Treasury yield

16

12

0
1871
1874
1878
1882
1886
1890
1894
1898
1902
1906
1910
1914
1918
1921
1925
1929
1933
1937
1941
1945
1949
1953
1957
1961
1965
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
2012
Chart 2

Low Yield (two-year bond yield) Eurozone Divergency (two-year bond yield)

10 10

8 8

6
6 EURO
4 PERIPHERALS
4
2
2
0
EURO
Sep-90

Sep-92

Sep-94

Sep-96

Sep-98

Sep-00

Sep-02

Sep-04

Sep-06

Sep-08

Sep-10

Sep-12

0
-2 CORE
Jun-10

Jun-11

Jun-12
Dec-09

Feb-10

Apr-10

Aug-10
Oct-10
Dec-10

Feb-11
Apr-11

Aug-11

Oct-11

Dec-11
Feb-12

Apr-12

Aug-12
-2
GERMANY FRANCE NETHERLANDS
BELGIUM AUSTRIA JAPAN GERMANY FRANCE ITALY
UK CANADA SWITZERLAND NETHERLANDS BELGIUM AUSTRIA
DENMARK SWEDEN US SPAIN PORTUGAL GREECE

During the fifties and sixties, expected returns were considered to be time-dependent. They
were estimated from asset fundamentals (e.g. the dividend discount model for stocks, the
yield for a bond, etc.). In the next two decades, thinking on the subject changed according to
the work of Ibbotson and Sinquefield (1976a and 1976b). They modelled equity expected
returns as a time-varying baseline given by cash or bonds, plus a constant term, the long-term
equity risk premium. In the eighties, the financial community came back to the origin: risk
premia were believed to be time-varying quantities themselves. This counterrevolution started
with Campbell and Shiller (1988a, 1988b) and continued with the works of Asness (2000),
Arnott (2002), and Fama & French (1989). Recently, Ilmanen (2011) faced the problem of
estimating expected returns on major asset-classes broadening the investments to non-
traditional assets (commodities, real estates), investment styles (value, trend, carry,
volatilities), and underlying factors (growth, inflation, illiquidity, and tail risks).

5
Current thinking today is more complex and closer to experimental evidences. Modern
approaches:

• derive asset-prices from asset returns co-variation with “bad times”;

• are based on multiple risk-factor models;

• incorporate time-varying risk premia, skewness and liquidity preferences;

• take into account supply-demand effects on asset prices; and

• model market inefficiencies due to investor irrationalities and market frictions.

We refer to Ilmanen (2011) as a comprehensive review on the subject.

Time-varying risk premia can be profitable if and only if investors are able to predict them.
Nevertheless the recent crises again call into question the predictability of asset-class risk
premia: neither a very simple normative approach like the Sharpe ratio can be applied easily
given the uncertainty on risk-free and high volatility of risk premia, nor can equilibrium-based
models be easily estimated given the rise in macroeconomic volatility. Today, researchers and
practitioners prefer to incorporate uncertainty and estimation errors in expected returns,
leading to Bayesian approaches (Black & Litterman model, 1990) and robust asset allocation
models (Meucci, 2011). Recently more extreme approaches emerged in the financial arena,
aiming to construct portfolios without any specific views on expected returns (e.g. minimum
variance, maximum diversification, risk parity approaches). Indeed, while the needs for
expected returns might be questionable in an optimisation process, it is evident that the long-
term estimates are absolutely crucial for pension funds and insurance companies to design
investment strategies to match their liabilities.

Rather than providing a specific recipe for estimating expected returns and computing return
figures, our aim here is to investigate this issue, stimulating the reader with relevant questions,
considerations, and few side empirical analyses to sustain our ideas. This manuscript is about
expected returns. Nevertheless, we will complement our considerations with historical
performance figures: even if the recent history is probably too peculiar to make extrapolations
from long-term time-series, there are always lessons that can be learned from history.

The paper is organised as follows. In section 1 we will start investigating how the crisis
changed the relationship between risk and return, and then questioning the possibility today of

6
calibrating a model on past history. Hence in section 2 we will introduce the two main classes
of estimation methods (Statistical and Equilibrium-based approaches) highlighting the pros
and cons, and stressing the peculiarity of the estimation problem in this specific era for
financial markets: in sections 3, 4, 5 and 6 we respectively critically evaluate the Sharpe ratio
approach, factors-model focusing mainly on the consequence of deflationary or inflationary
scenarios on asset-returns, reverse optimisation techniques to get implied returns from
equilibria allocation, and finally the equilibrium-based models. In section 7 we will then
illustrate how portfolio construction can help to handle uncertainty in expected returns to
deliver robust strategic asset allocation. A conclusive section delineates the main take-home
messages that we think are relevant to address expected return estimates in uncertainty. The
annex includes all the details about the charts and data-analysis presented in sections 1 and 3.

1. The financial crisis questions:

1.1. The relationship between risk and return

Past average returns are rarely related to future performance. Nevertheless past “bad”
performance can be somehow indicative of future returns: risk premia correspond to the
premium that an investor requires in order to be compensated for poor performance in “bad
times”. Chart 3a (redrawn from Ilmanen 2011) plots the compound average real returns from
1960 to 2009 in some US markets as a function of the average returns in “bad times” (1974,
1981, 2008) for financial markets and global economy. Even if the relationship is not clearly
linear, it is evident that assets that performed poorly in crisis periods delivered higher returns
in the long-run. This intuition is the key idea of modern theories on asset-pricing which, rather
than deriving prices from future discounted cash flows, build expected returns from asset
returns’ co-variation with “bad times”.

Given this argument, we measured the volatilities, maximum draw downs (MDD) 2, and
performance of some asset classes in two historical periods: pre-crisis sample (1990-2007)
and the full sample (1990-2012); see chart 3b in annex A1 for more details. The aim is to
show how the crisis period (2008-2012) brought new stress that was not priced in the pre-

2
While the MDD is related to the tail-risk and is sometimes related to specific historical events (local measure),
the volatility is a more general measure of returns dispersion (global measure).

7
crisis sample: higher volatility and worst MDD should suggest a higher premium for future
returns due to uncertainty.

The Eurozone debt crisis determined a marked increase in MDDs and volatilities in Euro
peripherals’ nominal bonds (the MDD of Italian bond doubled) and Euro inflation-linked
indices. The 2008 crisis was dramatic for spread markets: all volatilities increased markedly,
MDD for US investment grade more than doubled, World high-yield doubled its MDD, Euro
credit markets suffered less with respect to the pre-crisis period. The worst equity markets in
the crisis period were US, Euro peripherals, Australia and Emerging markets; the volatilities
of equity markets increased but only marginally with respect to the pre-crisis period.
Commodity indices registered new MDDs in the crisis sample, gold performed better during
the crisis (the average compound return increased); volatilities increased.

The crisis period increased long-term volatility in most of the asset classes. Most volatility
estimation models for strategic asset allocation are mainly based on Exponential Smoothing
techniques which overweight the recent history with respect to more distant history.
According to these approaches, the ex-ante volatility of many asset allocations is likely to
increase especially in the low-medium risk investor profiles where bond markets are mostly
allocated.

Chart 3 a

Redrawn from Ilmanen (2011)

8%
Compound Average Real Return, 1960-2009

7%
Small-Cap Stocks
6%

Stock Markets 5%
Real Estate
Commodity Futures 4%

Treasury Bonds High Yield Corporate Bonds

3%
Investment Grade Corporate Bond
2%
Treasury Bills
1%

0%
5% 0% -5% -10% -15% -20% -25% -30%
Average Real Return in Bad Times (1974, 1981, 2008)

8
1.2. The possibility of calibrating a model on past history

While recent history (few months) can moderately reflect near future performance (as trend-
follower strategies and CTAs demonstrated in the long run), it is rather dangerous to
extrapolate over multi-year time windows when reversals often take place.

In historical estimates, the sample period is crucial: long time windows reduce sample
specificity and allow for more robust statistical inference, but may miss structural changes
happening in the market and may not be able to catch up non-stationary risk premia dynamics.
On the other hand, small samples may lead to non–significant results, and give an incomplete
picture of the financial dynamics. Given the level of many financial indicators today, and the
emergence of structural changes in the world economy, it is rather difficult to select an
appropriate sample to estimate econometric models: recent history may or may not be
relevant. Chart 4 reports the rolling historical volatilities of German, Italian, and Spanish 7-10
year bonds (upper panel), and their rolling historical correlation to the EMU equity markets
(lower panel): the charts clearly show that the Eurozone moved from divergence to
convergence in the new millennium, and recently from convergence back to divergence again
with the debt crisis. The most relevant sample to estimates markets’ returns in this case is not
obvious. Financial markets are moving from pre-crisis equilibrium to a new one: at the
moment we are in between, and uncertainty prevents us from tracing a clear picture.

We calculated the new millennium performance (2000-2012) of US 10-year bonds and US

equity, and compared them with the past performance since 1871. In chart 5a we computed
the annualised compound returns for each decade. The average nominal figures for bonds and
equity are respectively 4.45% and 8.19% (real figures are respectively +2.48% and 6.14%).
Equity performance in the new millennium was very poor compared to the post-war period
1950-2000; however we should admit that the post-war period was misleadingly favourable to
equity, if compared with the full sample starting from 1871. In chart 5b we rearranged the
data in a scatter plot of the real performance of bonds and equity.

9
 Annualized performance

-0,8
-0,6
-0,4
-0,2
0
1

-1
0,2
0,4
0,6
0,8
10%
12%
14%
16%
18%
20%

0%
2%
4%
6%
8%

-5%
0%
5%
10%
15%
20%
Jan-93 Jan-93
Aug-93 Chart 4

Chart 5a
Aug-93
Mar-94

1870
Apr-94
Oct-94
Nov-94
May-95

1880
Jul-95
Dec-95
Mar-96
Jul-96

1890
Oct-96
Feb-97
Jun-97
Oct-97

1900
May-98 Jan-98

Dec-98 Sep-98

1910
Jul-99 Apr-99
Feb-00 Dec-99

1920
Sep-00 Aug-00
Apr-01 Mar-01

germany 7-10

germany 7-10

1930
Nov-01 Nov-01
Jul-02 Jun-02

bond
Feb-03

1940
Feb-03
Sep-03 Oct-03

equity
italy 7-10
italy 7-10

Apr-04

1950
May-04
Nov-04

cpi
Jan-05
Jun-05

1960
Aug-05
Jan-06
BOND 7-10 (historical volatility 1 yr rolling)

Apr-06

Nominal returns US 10-year bond & equity (1871-2012)

spain 7-10
Sep-06
spain 7-10

1970
Dec-06
Apr-07
BOND 7-10 (historical correlation to Equity EMU; 1 yr rolling)

Jul-07
Nov-07

1980
Mar-08
Jun-08
Jan-09
Oct-08

1990
Aug-09 Jun-09

Mar-10 Jan-10

2000
Oct-10 Sep-10
Jun-11 May-11
Jan-12

2012
Dec-11
Aug-12 Aug-12

10
avg
Chart 5b

Real performance per decade (1871-2012)

20%

1930
15%
1960 2000

1870
10%
Equity perf (ann)

1950 1900 1990

AVG
5% 1910 1890
1970
1880
1940
1980
0%
2012

-5% 1920

-10%
-10% -5% 0% 5% 10% 15% 20%
Bond perf (ann)

Equity in the new millennium did not offer any spread over inflation: this pattern on equities
was similar to the seventies when high inflation caused a bear equity market 3. On the bond
side, performance in the new millennium was higher than the long-term average: bonds
benefited from the marked fall in interest rates (see chart 1). A final remark on correlation
between performance of bond and equity: the scatter plot shows that, on a ten-year horizon,
they were on average positively correlated. This paradigm was not verified only from the
beginning of 1941 to the end of 1980, when bonds suffered from the increase in 10-year
interest rates from 1.95% to 12.84%, delivering a negative real performance.

This analysis highlights the importance of extending the historical sample. In addition, in
order to get more robust estimates it might be wiser to complement model-free historical
figures with models from financial theories, models from behavioural theories, forward-

3
In the 1970-1980 decade the annual inflation rate was +8.05%.

11
looking market indicators (e.g. valuation ratios), discretionary views may help as well in case
of strong structural changes.

2. Should expected returns reflect an unbiased view about the market, or should
they incorporate economic scenario expectations and/or recent history
information such as valuation?

The approaches to estimate expected returns can be divided in two main categories: statistical
methods and equilibrium-based models. The separation between them is not very neat. Both
of them are certainly statistical as most of the models are derived according to econometric
relations, and both of them can be built on macroeconomic relationships among variables. The
main differences between them are that the former do not assume any specific
macroeconomic views, and are not equipped with valuation tools. We would say that while
statistical models estimate returns mainly looking at the past history, equilibrium-based
models forecast future returns incorporating forward looking macro variables.

2.1 Statistical methods.

We intend with these approaches:

• a normative method based on Sharpe ratio hypothesis;

• factors-model approaches based either on statistical analysis tools (e.g. principal

component analysis, independent component analysis), or on more fundamental
methods looking at asset-classes as vehicles of more systematic factors (e.g. CPI,
GDP, Illiquidity, Risk Aversion); and

• reverse optimisation techniques (Cantaluppi; 1999) to get expected returns from an

equilibrium portfolio.

The above approaches:

• lead to unbiased and, hence, more robust expected returns,

12
 • are good candidates for portfolio optimisation leading to well-posed solutions and
diversified portfolios 4;

• but are not very appropriate for computing discount rate for pension funds and
insurance companies.

2.2 Equilibrium-based methods.

We mean models based on macroeconomic assumptions (e.g. long-term expectations on

inflation and GDP) and valuation arguments. They are:

• good candidates for computing discount rate;

• superior to forecast future returns;

• sometimes they lead to corner solutions in an optimiser.

In this document we do not face the class of Behavioural models. These approaches enable us
to explain many observed anomalies in risk premia 5, and might be useful to diversify
statistical and equilibrium models. This way may lead to more robust estimations.

3. Sharpe ratio, is a simple constant figure still relevant?

Sharpe ratio is a risk-adjusted performance measure, and it is usually used to assess the
efficiency of an asset-class, investment strategy or fund. Sharpe ratio is usually computed as
the average excess return of a risky asset over the risk-free rate and normalised for historical
volatility. We prefer instead to compute the Sharpe ratio as the difference between the
annualised compound returns of the risky asset and the risk-free rate divided by the
annualised volatility. According to this formulation the expected return can be expressed as
the risk-free plus a term given by the ex-ante volatility times the Sharpe ratio.

Sharpe ratio presents the following difficulties:

• What is the risk-free rate?

4
Maximum-diversification portfolios are obtained maximising the (ex-ante) Sharpe ratio under the hypothesis of
constant Sharpe ratio across all asset-classes (Choueifaty and Coignard, 2008).
5
The equity premium puzzle indicates the difficulty of explaining the observed equity risk premium within
standard macroeconomic models. Behavioural models provide an explanation (see Bernatzi and Thaler 1995, and
Barberis and Huang 2001).

13
Usually it corresponds to a short-term or long-term government yield, but which one now?
Government debt may no longer be risk-free. Chart 6 reports the 10-year CDS for Italy and
Germany from 2005.

• Instability over time

Chart 7 plots the Sharpe ratio for the US, Japanese, UK, German and French equity markets.
Computations have been performed on rolling windows of 10- and three-year horizons. The
longer the time window, the more stable the Sharpe ratio. Table 1 in annex A2 reports some
descriptive statistics: the median and the average figures are reported for each country and
three-, five- and 10-year time horizons. For the equity markets, 0.25 is a reasonable estimate
for the 10-year horizon.

Chart 6

CDS 10 yrs (USD)

600
500
400
300
200
100
0
04/01/2005

04/04/2005

04/07/2005

04/10/2005

04/01/2006

04/04/2006

04/07/2006

04/10/2006

04/01/2007

04/04/2007

04/07/2007

04/10/2007

04/01/2008

04/04/2008

04/07/2008

04/10/2008

04/01/2009

04/04/2009

04/07/2009

04/10/2009

04/01/2010

04/04/2010

04/07/2010

04/10/2010

04/01/2011

04/04/2011

04/07/2011

04/10/2011

04/01/2012

04/04/2012

04/07/2012

04/10/2012

italy germany

14
Chart 7

Historical Sharpe ratio (10yrs rolling)

2,5

1,5

0,5

-0,5

-1

-1,5

-2
juil.-65

juil.-67

juil.-69

juil.-71

juil.-73

juil.-75

juil.-77

juil.-79

juil.-81

juil.-83

juil.-85

juil.-87

juil.-89

juil.-91

juil.-93

juil.-95

juil.-97

juil.-99

juil.-01

juil.-03

juil.-05

juil.-07

juil.-09

juil.-11
USA JAPAN GERMANY FRANCE UK

Historical Sharpe ratio (3yrs rolling)

2,5

1,5

0,5

-0,5

-1

-1,5

-2
juil.-65

juil.-67

juil.-69

juil.-71

juil.-73

juil.-75

juil.-77

juil.-79

juil.-81

juil.-83

juil.-85

juil.-87

juil.-89

juil.-91

juil.-93

juil.-95

juil.-97

juil.-99

juil.-01

juil.-03

juil.-05

juil.-07

juil.-09

juil.-11

USA JAPAN GERMANY FRANCE UK

• Differences among asset classes. Does it make sense to make a normative assumption
of equal Sharpe ratios for all asset classes?

Recently, practitioners and researchers (see Frazzini & Petersen 2010) documented some
anomalies regarding the Sharpe ratio. We report in the following the most relevant:

• On historical basis low volatility asset-classes delivered higher Sharpe ratio 6. This
evidence inspired minimum-variance investments in the equity markets. We tested this
hypothesis in different baskets, as follows:

6
As reported by Asness et al. (2011), if investors are leverage averse, low-beta assets will offer higher risk-
adjusted returns, and high-beta assets lower risk-adjusted returns. Leverage aversion breaks the standard CAPM.

15
 Diversified basket. We considered a diversified investment universe in the US market
since 1970 (see annex for details). Chart 8 (top left panel) reports the Sharpe ratio as a
function of the volatility. Each spot stands for a specific asset-class. The plot shows
clearly a reverse relation of the Sharpe ratio to the volatility (linear regression; R2 is
0.9401). When dealing with diversified investment universe, this relation is
particularly sample specific: restricting the analysis within each macro asset-class can
alleviate this problem.

Equity markets. In chart 8 (top right panel) we investigated the bias of Sharpe ratio
towards low volatility segments measuring the Sharpe ratios for each sector of US
equity market, and plotting them against the volatilities. The plot confirms the
anomaly, even if the relation is noisy (linear regression; R2 is 0.2210). In chart 9
(lower panels) we report two pictures taken from Baker et al. 2011. They studied the
US equity market from January 1968 to December 2008.

Chart 8

US Diversified (1971-2012) US MSCI Sectors (1995-2012)

0,60 0,50

0,50 0,40

0,30
0,40
sharpe (ann)

sharpe (ann)

0,20
0,30
0,10
0,20
0,00

0,10 -0,10

0,00 -0,20
0% 5% 10% 15% 20% 25% 0% 10% 20% 30% 40%
vol (ann) vol (ann)

16
 Each month they sorted stocks into five groups according to their historical volatilities
calculated on five-year trailing windows. They did the analysis twice: left panel
reports the analysis performed on all the stocks, right panel on the 1,000 largest stocks
according to their market capitalisation. The plots show clearly the outperformance of
low volatility stocks over high volatility ones. They complement the analysis replacing
volatility as a risk measure with beta, and they found similar results.

Bond markets and Credit markets. As reported in Ilmanen (2011) a similar rule holds
for bond and credit markets: lower maturity bonds reported a higher Sharpe ratio than
longer maturity ones, and similarly higher quality credit buckets historically delivered
higher Sharpe ratios than lower rated credit ones.

• Diversified indices delivered higher Sharpe ratios. We tested this argument in chart 9.
We measured the Sharpe ratio for the EMU equity markets from 2002 to 2007. The
Sharpe ratio is 1.30 which is greater than most of each country’s ones. The arithmetic
average of the Sharpe ratio cross-countries is 1.09 (the weighted average according to
the market cap is 1.19; we made an approximation of keeping the market cap constant
over time). The result confirms the benefit of diversification.

• Illiquid asset classes historically delivered higher Sharpe ratios with respect to liquid
assets (see Ilmanen, 2011). In the long run, less liquid assets offer a compensation for
the higher trading costs and lower flexibility to rebalance portfolio positions. From an
estimation point of view, illiquid assets tend to exhibit smoothed prices thus leading to
underestimation of the true risk; this estimation error is certain to artificially increase
the Sharpe ratio.

Chart 9

Sharpe ratio EMU area 2002-2007

2,00 1,73
1,60 1,32 1,30
1,09 1,06 1,09 1,19
1,20 0,85 0,94
0,80 0,62
0,40
0,00
NETHERTLAND

FINLAND

EMU avg
GERMANY

SPAIN

BELGIUM

EMU
ITALY

EMU avg2
FRANCE

17
The observation that Sharpe ratio of asset-classes is higher for low volatility and more
diversified assets seems to be sufficiently documented in order to be taken into account.
However, the level of this anomaly may be sample specific; as an example, the exceptionally
favourable Sharpe ratio of bonds has been driven by a significant decline in interest rates.

A more detailed approach than the constant Sharpe ratio method may be required to set up the
expected returns to calculate the discount rate. However when it comes to portfolio
construction we should note that taking advantage of high Sharpe ratio for low volatility asset
classes is only possible when leveraging portfolios or for very low risk profiles. In addition,
the constant Sharpe ratio approach leads to a better diversified portfolio in terms of risk;
therefore except in very particular case this approximation may be kept to building strategic
allocation in diversified portfolios.

• Non-normality of asset classes

The Sharpe ratio implicitly assumes volatility as the risk measure. In case of strong
asymmetric and fat-tailed asset classes, the approximation is too rough, and the Sharpe ratio
becomes unreliable. In this case many practitioners and researchers prefer to correct the
formula by replacing the volatility with the downside volatility (Sortino ratio), or maximum
draw down. Nevertheless we should remind the reader that volatility misses some important
aspects of risk: liquidity risk, default risk, higher order statistics and tail risk, model risk,
timing risk, valuation risk, and fundamental risk, and that is going to have implications on the
estimation of the Sharpe ratio.

4. New trends in asset allocation look at assets as vehicles of more fundamental

macroeconomic variables, stress and liquidity indicators. It is evident that
potential inflation caused by unconventional monetary policy of central banks on
one hand, and possible extended recession and hence deflation on the other hand,
make inflation a key variable in order to decipher the future market scenario.
Hence, what are the implications of inflationary or deflationary scenarios on
asset returns?

Inflation refers to a rise in the consumer price level and consequently to a reduction in the real
value of money. While rising inflation is usually related to poor conditions in the real
economy, disinflation (i.e. a slowdown of inflation to lower levels) is commonly associated

18
with better economic conditions. Deflation consists in a fall in consumer prices: it hurts the
real economy because of a potential spiral in consumer prices, and the consequent recession
and depression. Deflation affected many countries in the past: the US’s Great Depression in
the 30s, Japan from 90s to present times, and Hong Kong from 1997 to 2004.

The first issue we want to address is the likelihood of deflationary and inflationary scenarios
on a historical basis. Chart 10a reports the annual inflation rates for US (from 1871) and
Sweden (from 1900).

It is evident that the last millennium was mainly characterised by positive inflation rates;
hence it is questionable whether deflationary periods were less likely than inflationary ones.
As Reinhart and Rogoff (2011) demonstrated, on longer historical perspective, inflation and
deflation were both well represented: according to their study the 20th century itself represents
an anomaly. Secondly we analysed the historical performance of asset classes conditional to
contemporaneous inflation rate variation (on an annual basis). We divided the inflation rates
into buckets to separate different scenarios:

• deflation: negative inflation rates;

• low inflation: inflation rates between 0% and 2%;

• moderate inflation: inflation rates between 2% and 5%;

Chart 10a

Inflation rates US (1871-2012) and Sweden (1900-2012)

50%
40%
30%
20%
10%
0%
-10%
-20%
-30%
1871
1876
1881
1886
1891
1896
1901
1906
1911
1916
1921
1926
1931
1936
1941
1946
1951
1956
1961
1966
1971
1976
1981
1986
1991
1996
2001
2006
2011

us sweden

19
• high inflation: inflation rates between 5% and 10%;

• very high inflation: inflation rates higher than 10%.

Then we computed the annualised real performance of major asset classes conditional to the
above inflation scenarios. Chart 10b reports the outcome of the analysis for US 10-year bonds
and equity from 1871 to September 2012, and for Swedish bonds and equity from 1900 to
September 2012. For each bucket we plot the average, the minimum and maximum
performance as a proxy of the dispersion. Three main messages emerge:

• nominal bonds are a good hedge for deflationary scenarios;

• high inflation hurts nominal bonds: inflation rates greater than 5% lead to negative
average performance in US and close to zero in Sweden;

• the high dispersion of returns for equity markets highlights that inflation is not the main
driver in this case.

In chart 10c we performed the same exercise for US corporate investment grade all maturities,
US corporate investment grade intermediate maturity, commodity GSCI and gold. We
investigated the dependency with respect to the US inflation rates. Time series are shorter in
this case: our sample is from 1970 for investment grade corporate and commodity GSCI, and
from 1927 for gold 7. The main take-home messages are:

• corporate investment grade mimics the behaviour of bonds, hence inflation hurts corporate
investment grade;

• commodity GSCI is a good hedge against inflationary scenarios;

• gold does not reward significantly over inflation on high inflation scenarios (as noted in
footnote 7, the very high inflation scenario is not significant in this case).

In Pola (2013) we will more carefully illustrate the dependency of asset returns on
macroeconomic variables, showing how to segment asset classes according to their attitude to
polarise with respect to variations of macroeconomic variables (rising or falling scenarios).

7
In this case results on extreme scenarios (deflation and very high inflation) should be taken with care. The
sample from 1970 only has three entries for very high inflation scenarios and zero for deflationary scenarios. The
sample from 1927 only presents four entries for very high inflation scenarios and seven for deflationary
scenarios.

20
Chart 10b

US Bond 1871-2012 conditional to CPI rate buckets US Equity 1871-2012 conditional to CPI rate buckets

60% 60%

50%
40%
40%
real performance (annualized)

real performance (annualized)

30% 20%

20%
0%
10%

0% -20%

-10%
-40%
-20%

-30% -60%
<=0% (0%; 2%] (2%; 5%] (5%; 10%] >10% <=0% (0%; 2%] (2%; 5%] (5%; 10%] >10%

min avg max min avg max

Sweden Bond 1900-2012 conditional to CPI rate buckets Sweden Equity 1900-2012 conditional to CPI rate buckets

80% 100%

80%
60%
real performance (annualized)
real performance (annualized)

60%
40%

40%
20%
20%
0%
0%

-20%
-20%

-40% -40%

-60% -60%
<=0% (0%; 2%] (2%; 5%] (5%; 10%] >10% <=0% (0%; 2%] (2%; 5%] (5%; 10%] >10%

min avg max min avg max

Chart 10c

US Corporate IG 1970-2012 conditional to US CPI rate buckets US Interm Corporate IG 1970-2012 conditional to US CPI rate
buckets
40% 40%

30%
30%
real performance (annualized)

real performance (annualized)

20%
20%

10%
10%
0%

0%
-10%

-10%
-20%

-20% -30%
<=0% (0%; 2%] (2%; 5%] (5%; 10%] >10% <=0% (0%; 2%] (2%; 5%] (5%; 10%] >10%

min avg max min avg max

Commodity GSCI 1970-2012 conditional to US CPI rate Gold 1927-2012 conditional to US CPI rate buckets
buckets
80% 60%

60%
40%
real performance (annualized)

real performance (annualized)

40%
20%

20%
0%
0%

-20%
-20%

-40%
-40%

-60% -60%
<=0% (0%; 2%] (2%; 5%] (5%; 10%] >10% <=0% (0%; 2%] (2%; 5%] >5% >10%

min avg max min avg max

21
5. Reverse optimisation, what can it be used for?

The Markowitz model strongly depends on expected returns assumptions, and sometimes
produces results that are extreme and not particularly intuitive. The remedy of Black &
Litterman (1990) was to firstly identify a reference point for expected return assumptions
(equilibrium expected return), and then to elaborate a consistent Bayesian framework to
integrate qualitative views.

The main assumption beyond the equilibrium expected return is that, according to the Capital
Asset Pricing Model (CAPM), “prices will adjust until the expected returns of all assets in
equilibrium are such that if all investors hold the same belief, the demand for these assets will
exactly equal the outstanding supply” (He & Litterman 1999). The procedure to determine the
implicit returns in the market portfolio consists in reverse engineering the mean-variance
method: the aim is to determine the expected returns according to which the market portfolio
is optimal; this procedure is known in literature as reverse optimisation (Cantaluppi 1999).
This approach is more general than its application in the Black & Litterman (1990) model:
according to the reverse optimisation technique, implicit returns can be extracted from any
strategic asset allocation.

Reverse optimisation is a valuable tool for achieving consistency between model portfolios
and the fund manager’s portfolio. The iterative process that enables the allocation to be
transformed in implied views (reverse optimisation), and then the expected views in a
portfolio (optimisation), allows fund managers to build their portfolios more coherently.

Reverse optimisation implied returns suffer the following difficulties:

• requires calibration of a risk aversion parameter

The risk aversion parameter corresponds to the expected risk-return trade-off. It is the rate at
which more return is required for more risk, and it can be expressed as the ratio of risk
premium and variance of the market portfolio. This approach becomes decreasingly intuitive
when dealing with a diversified investment universe including bonds, equities, commodities
and alternative assets. In this case the most popular approach consists in determining the risk
aversion parameter according to a strong prior information or conviction (e.g. the return of a
short-term bond). Given the debt crisis in the Eurozone, this issue remains a critical one.

22
• favours overshot assets (no mean reversion mechanism) when applied to the market
cap

According to the reverse optimisation technique, returns are proportional to the market cap,
hence the approach suffers from increasing the returns of assets which are in a bubble. No
mean reversion mechanisms are present to alleviate the problem.

• assumes no segmentation in markets and no constraints

The model does assume that investors can buy any markets without any regulatory
constraints. Indeed it does not include some bias, such as the home bias, for example,
according to which investors tend to overweight assets of their own country.

6. Equilibrium-based model

The financial crisis questions the possibility of setting up reasonable forward looking
equilibrium figures due to uncertainty on long-term macroeconomic prospect trends.
What is the impact of this uncertainty on asset class return forecasts? And what is the
confidence on expected returns?

One of the most common approaches for forecasting returns in an equilibrium-based

framework consists in the building block approach. According to this model, we need to
forecast: the long-term inflation rate, the real risk-free rate (which corresponds to the
premium of the risk-free rate over inflation) and the risk premium (which corresponds to the
risk premium of risky assets over risk-free assets). Equilibrium-based models usually assume
that the valuation of markets against fundamentals converge to some historical average or
fundamental level.

In the past this approach was able to produce coherent figures. The developed world economy
had been characterised by decreasing inflation and decreasing volatility in growth and
inflation in the '90s (see chart 11). This allowed monetary policy rates to be generally lower
and more stable than in the '70s and the '80s. In particular, inflation expectations stabilised at
fairly low levels over the '90s. Therefore, in this more stable environment, rates tended to also
be more stable and more in line with nominal growth: this represented the first assumption.

23
Chart 11

US GDP & CPI rolling volatility (5 yrs rolling)

3,50%
3,00%
2,50%
2,00%
1,50%
1,00%
0,50%
0,00%
déc.-57

déc.-59

déc.-61

déc.-63

déc.-65

déc.-67

déc.-69

déc.-71

déc.-73

déc.-75

déc.-77

déc.-79

déc.-81

déc.-83

déc.-85

déc.-87

déc.-89

déc.-91

déc.-93

déc.-95

déc.-97

déc.-99

déc.-01

déc.-03

déc.-05

déc.-07

déc.-09

déc.-11
GDP CPI

The second assumption was represented by the empirical evidence of a positive relationship
between performances and risks measured by volatility over a long period. This environment
favoured equilibrium-based model approaches. Current market conditions are now far more
uncertain, and they make it difficult to apply this approach because econometric relations to
estimate risk premia might not be robust in non-stationary markets.

Furthermore, the monetary policy regime changed as well: extraordinary measures like
quantitative easing were introduced over recent years by many central banks as a new policy
response to the crisis. At the same time the assumption on the link between return and risk
over the long term has also come under scrutiny.

Even if “forward-looking indicators, such as valuation ratios, have a better track record in
forecasting asset class returns than rearview-mirror measures” (Ilmanen 2011), we should
remind the reader that returns sometimes may never revert over a practical time frame. Chart
12 reports the time-series of US bonds, US equity and Japanese equity in specific time
periods. The figures are contrasted to a hypothetical long-term average and dispersion (see
annex for details). The plots show clearly that the return-to-the-mean sometimes is very slow,
and that risk premia can exhibit robust trends which can last for many decades.

The best way to overcome difficulties in equilibrium-based models and valuation approaches
rely on diversifying the estimation process with complementary models.

24
 7.
Cumulative Performance (logarithm) Cumulative Performance (logarithm) Cumulative Performance (logarithm)

-1,5
-0,5
-1,5
-0,5
-0,2

-1
0,5
1,5
2,5
3,5
-2
-1
0,5
1,5
0,2
0,4
0,6
0,8
1,2

0
1
2
3
0
1
2
0
1
1989,12 1929,12 1964,12 Chart 12
1990,07 1930,05 1965,06
1991,02 1965,12
1930,1
1991,09 1966,06
1931,03
1992,04 1966,12
1992,11 1931,08
1967,06
1993,06 1932,01
1967,12
1994,01 1932,06
1968,06
1994,08 1932,11 1968,12
1995,03
1933,04 1969,06
1995,10

rid of expected returns?

1933,09 1969,12
1996,05
1934,02 1970,06
1996,12
1934,07 1970,12
1997,07
1971,06

mkt

mkt
mkt
1998,02 1934,12
1998,09 1971,12
1935,05
1999,04 1972,06
1935,10
1972,12
median

1999,11

median
median
1936,03
2000,06 1973,06
2001,01 1936,08 1973,12
2001,08 1937,01 1974,06
+2sigma

+2sigma
+2sigma
2002,03 1937,06 1974,12
2002,10 1975,06
1937,11
2003,05 1975,12
1938,04
-2sigma

-2sigma
-2sigma
US Bond 1965-1981 (Cumulative Return)

2003,12
US Equity 1929-1942 (Cumulative Return)

1976,06
1938,09

Japan Equity 1990-2012 (Cumulative Return)

2004,07
1976,12
2005,02 1939,02
1977,06
2005,09 1939,07
1977,12
2006,04 1939,12
1978,06
2006,11
1940,05 1978,12
2007,06
1940,10 1979,06
2008,01
2008,08 1941,03 1979,12

2009,03 1941,08 1980,06

2009,10 1942,01 1980,12

2010,05 1981,06
1942,06
2010,12 1981,12

The last decade in the equity market has been particularly dramatic for diversified asset
allocation such as pension funds and balanced portfolios: poor performances, large draw-
How to handle uncertainty in expected returns? Can strategic asset allocation get

25
downs and very slow recovery again call into question the predictability of risk premia, and
the effect of incorrect assumptions in the portfolio optimisation process.

In the eighties and nineties, Jobson and Korkie, (1980), Best and Grauer (1991), Chopra and
Ziemba (1993) demonstrated that the sub-optimality due to estimation risk can be dramatic.
This evidence led researchers and practitioners to investigate more robust portfolio
construction schemes which can alleviate the estimation risk in the portfolio construction
process. The main approaches are the Bayesian methods and the robust models. The most
famous Bayesian method is the Black-Litterman (1990) model. Robust allocations deal with
uncertainty of input parameters by choosing the best allocation in the worst market condition
within a given uncertainty range. Indeed, the choice of this range is quite arbitrary. Robust
Bayesian allocations enable the uncertainty region for the input parameters to be defined in a
more coherent way. Moreover, the approach allows investors to modify the region according
to their specific views. Meucci (2011) consider robust Bayesian allocations that also account
for the estimation errors in co-variances.

More recently, the financial industry moved even further, elaborating investment processes
that can completely neglect assumptions on expected returns. The most popular were the
minimum variance, the maximum diversification portfolios, and the risk parity approach (see
Clarke et al. 2012). While the former has been used for equity portfolios, the seconds are
good candidates for diversified allocation. These portfolio construction schemes allow the
investor to make allocation according (only) to a risk model for the asset-classes. The
portfolio construction implication of these approaches is the overweight of low risk assets,
and thus the need for leveraging allocations in order to match medium-high risk profile
without losing equilibrium among portfolio’s bets.

Risk-parity approach is proven to be superior to the traditional mean-variance solution in case

of high uncertainty in the input parameters. Meucci (2009) proposed a diversification measure
which allows investors to diversify portfolios on independent factors (principal components).
More recently the need for diversification led researchers and practitioners to explore new
directions, thus complementing traditional asset classes (bonds and equities) with
commodities, real estate, investment styles (value, trend, carry, volatilities), and factors
(growth, inflation, illiquidity, and tail risks). The virtue of the risk-parity approach is
robustness in portfolio construction, the limit is that it is difficult to match it with a specific

26
macroeconomic view. In some cases, risk-parity models end up being pure statistical tools to
diversify unobservable information.

In Pola and Facchinato (2013), we illustrate a new approach for strategic asset allocation
(DAMS) which can be helpful to build more robust estimates for expected returns in
uncertainty. The key assumption of the Black-Litterman approach is to identify a reference
point for expected returns from reverse engineering the market portfolio (according to the
CAPM hypothesis). Given the limits of the CAPM hypothesis, it might be wiser to define the
reference expected returns from a different perspective. In Pola and Facchinato (2013) we
introduce a new reference portfolio where different macroeconomic scenarios are in
equilibrium, thus expressing the current uncertainty in financial markets.

8. Conclusion

The recent crisis exhibited major changes in the risk level, in the observed risk premia and the
risk-return relationship among asset classes. Many financial variables are in an uncharted
region, never reached going back many decades, and more than a century in some cases:
whether they would revert to the mean or they would stabilise to new levels is not clear (e.g.
Euro peripherals’ bond market). The uniqueness of the level reached by many financial
variables should at least convince us to lower our confidence on predictability of asset
classes’ risk premia.

We investigated the effectiveness of statistical methods, and equilibrium-based approaches:

high non-stationary patterns for the Sharpe ratio on one hand, the increase in macroeconomic
volatility on the other hand, make it difficult to use recent historical time-series to calibrate
econometric models. Increasing the length of history and identifying the observed risk-return
under different market regimes may help to clarify the picture. We briefly investigated the
dependency of main asset classes on inflation. Main results are:

• in inflationary scenarios nominal bonds suffer, gold does not provide excess return over
inflation, whereas more diversified commodity indices offer better real performances;

• in deflationary scenarios, nominal bonds are the best hedge.

Even if inflation hurt US stocks in the seventies and eighties, the dependency of equity on
inflation is not clear: going back to 1871 in the US and 1900 in Sweden, high dispersion of

27
conditional equity returns on inflation buckets, suggests to us that inflation is not the primary
risk driver.

Investigating the Sharpe ratio as a function of volatility, we show a rich phenomenology

according to which low volatility investments, higher quality credit bonds, less liquid assets,
and more diversified indices delivered, on historical basis, higher Sharpe ratios. Despite these
empirical evidences, we should point out that a normative hypothesis of equal Sharpe ratio for
each asset class allows us to build more diversified portfolios. Indeed whenever the portfolio
expected return is relevant per se (e.g. determining the discount rate for pension funds and
insurance companies), we prefer a more detailed description of asset classes’ Sharpe ratio. On
a more practical basis, 0.25 is a reasonable estimate for the Sharpe ratio of equity markets for
single countries and a ten-year horizon; global equity indices are likely to deliver higher
Sharpe ratios due to index diversification.

The directions which we would like to advice to tackle the expected return issue in this new
environment are:

• mix several complementary approaches to determine long-term expected returns, relying

on pluri-disciplinary skills (macroeconomics, econometrics and quantitative finance,
behavioural models are important as well to explain many documented anomalies in the
markets);

• relying more on risk to construct portfolios (e.g. minimum variance, maximum

diversification and risk parity portfolio construction).

This pluri-disciplinary approach may overcome some of the difficulties experienced by both
statistical and equilibrium-based approaches, leading to better adapted figures both to build
robust allocations and set up a realistic future level of expected returns and discount rate of
liabilities.

28
Acknowledgements

We would like to thank Eric Tazé-Bernard, Sergio Bertoncini, Jean-Renaud Viala, and Marc-
Ali Ben Abdallah for very stimulating discussions and very constructive suggestions.

29
ANNEX A1

In chart 3b we measured the volatilities, maximum draw downs (MDD), and performance of
some asset classes in two historical periods: pre-crisis sample (1990-2007) and the full sample
(1990-2012). The grey shaded areas in chart 3b signal markets that exhibit a worse MDD than
before, bold indicates an increase in volatility.

Bond markets. The issue is the decoupling of the Eurozone: Italy’s MDD doubled in the
crisis period. Nevertheless Germany suffered between the end of 2011 and first quarter of
2012. In the Eurozone, French bonds did not exhibit any draw-downs not priced before. With
the exception of Australian, Canadian, and Japanese bonds, all volatilities increased.

Inflation linked markets. Eurozone debt crisis drove the main changes: the euro index
presents the higher increase in volatility. The emerging inflation-linked market is not very
significant due to small data sample: anyway data indicate that they deliver the best
performance per unit of volatility across all asset classes.

Credit markets. The 2008 crisis was a dramatic year for most of the spread markets. MDD
for US investment grade more than doubled, euro investment grade suffered less. World high
yield doubled its MDD, even though the euro high yield did not suffer its worst draw down in
the crisis period (the MDD in the full sample was from February 2000 to September 2002).
All volatilities increased except for the emerging market debt in hard currencies.

Equity markets. The crisis increased the MDDs in US, Euro peripherals, Australia and
Emerging markets. Germany, France, UK, Japan, and Canada did not register worst draw
downs. The volatilities increased but only marginally with respect to the pre-crisis period.

Commodity markets. CRB and GSCI indices registered new MDDs in the crisis sample,
gold performed better in the crisis (the average compound return increased). The increase in
volatility of CRB was more marked with respect to the GSCI and gold; the difference between
CRB and GSCI indices is mainly due to the larger exposure of CRB to energy commodities.

30
Chart 3b

31
ANNEX A2

In the following we report the median and average Sharpe ratio computed in different equity
markets and according to different-sized rolling windows (10 years, 5 years, 3 years)

Table1

MEDIAN 10 yrs 5 yrs 3 yrs AVERAGE 10 yrs 5 yrs 3 yrs

USA 0,29 0,27 0,35 USA 0,27 0,33 0,40
Japan 0,19 0,21 0,19 Japan 0,20 0,24 0,29
Germ any 0,21 0,09 0,10 Germ any 0,18 0,19 0,24
France 0,30 0,14 0,10 France 0,23 0,21 0,28
UK 0,26 0,28 0,32 UK 0,24 0,29 0,38

ANNEX A3

Chart 1

The plot reports the US Treasury yield 10-year. Data provider is Schiller database.

Chart 2

The plot reports the two-year yields for international countries: Germany, France,
Netherlands, Belgium, Austria, Italy, Spain, Portugal, Greece, Japan, UK, Canada,
Switzerland, Denmark, Sweden, US. Data provider is Bloomberg.

Chart 3a

Chart 3a is redrawn from Ilmanen (2011). It reports the performance of various US markets
from 1960 to 2009. The scatter plot relates the compound average real return (Y-axis) to the
average real losses in the three worst years (1974, 1981, 2008) for financial markets and the
global economy.

Chart 3b

Chart 3b contrasts the performance, volatility, and Maximum Draw Down of various indices
in two samples: pre-crisis sample (1990-2007) and the full-sample (1990-September 2012).
All time-series are monthly and in local currency. A few indices are shorter due to their

32
inception: World Inflation Linked since Dec. 1996, Euro Inflation Linked since Dec. 1999,
Emerging Inflation Linked since Dec. 2003, Credit Euro IG since Dec. 1995, Credit Euro HY
since Dec. 1997, Emerging Debt in Hard currency since Dec. 1993, Emerging Debt in Local
currency since Dec. 1993, Spanish equity since Dec. 1998, Australian equity since May 1992,
commodity CRB since January 1994. Data provider is Bloomberg.

Chart 4

The plot reports the historical 1-year rolling volatility (top panel) for German, Spanish and
Italian 7-10 year bonds, and their historical 1-year correlation to the EMU equity market.
Time-series are daily, data provider is Bloomberg.

Chart 5a & 5b

The left chart reports the performance of US bonds, US equity, and compares them to the
inflation rates in the same period. Performances are presented in decades (except for the last
“decade” which includes 12 years). The vertical bar divides the sample in three periods: pre-
war, post-war and new millennium. The right panel reports a scatter plot between real
performance for US bonds and US equity. Each spot corresponds to the annualised
performance of bonds and equity for a specific decade. Data provider is Schiller database.

Chart 6

The plot reports the 10-year CDS for Italy and Germany since 2005. Data provider is
Bloomberg.

Chart 7

The plot reports computations of Sharpe ratio over rolling windows (10 and 3 years) of
various equity markets (US, Japan, UK, Germany, France). Time-series are monthly. Table 1
in annex A2 reports the summary of the results: median and average for countries and
horizons (10, 5, 3 years). Data providers are Datastream and Bloomberg.

Chart 8

In chart 8 (top left panel) we computed the historical Sharpe ratio and plot against historical
volatility in a diversified investment universe in the US. The risky assets are: short-term
treasury, all-maturity treasury, long-term treasury, short-term corporate investment grade, all-
maturity corporate investment grade, long-term corporate investment grade, all-maturity

33
corporate high yield, equity, gold, commodity GSCI and commodity CRB. All time-series are
monthly from 31/01/1973 up to 29/08/2012, except long-term treasury from 31/01/1990, all-
maturity corporate high yield from 31/07/1983, and commodity CRB from 31/01/1944. Risk-
free to compute the Sharpe ratio is the three-month T-bill. Data provider is Bloomberg.

Chart 8 (top right panel) reports the historical Sharpe ratio as a function of the historical
volatility for the US MSCI Sectors from 1995 to 2012. Time-series are monthly. Data
provider is Bloomberg.

Chart 8 (bottom panels) have been taken from Baker et al. 2011.

Chart 9

The chart reports the historical Sharpe ratio for EMU equity and for the most relevant
countries in the index (France, Germany, Spain, Netherlands, Italy, Belgium, Finland). Time-
series are monthly from 2002 to 2007. Data provider is Bloomberg.

Chart 10a

The charts report the yoy inflation rates for US and Sweden respectively from 1871 and 1900.
Data providers are Bloomberg, Schiller database, DMS.

Chart 10b & 10c

The charts report the conditional performance of asset-classes from US and Sweden (from
1871 and 1900 respectively) with respect to inflation rate buckets, as reported in the X-axis.
Performances are annualised and adjusted for inflation. For commodity GSCI and commodity
we take the point of view of a US investor. Data providers are Bloomberg, Schiller database,
and DMS.

Chart 11

The chart reports the historical volatility over five-year rolling windows for US inflation and
US real GDP. Time-series are monthly from 1957 to 2012. Data provider is Bloomberg.

Chart 12

The chart reports the time-series of US bonds, US equity, and Japanese equity in specific time
periods. The figures are contrasted to a hypothetical long-term average and dispersion. Ex-
ante estimates at the beginning of the period have been computed assuming:

34
 • constant drift. We assumed a constant Sharpe ratio (0.20) and a risk-free rate given by
the 10-year bond yield at the beginning of the sample;

• constant volatility. Historical volatilities in the previous decade (monthly

observation).

Data providers are Bloomberg and Schiller database.

35
References

Arnott, R. D., and Bernstein, P. L., 2002. “What Risk Premium Is ‘Normal’?”, Financial
Analysts Journal, vol. 58, no. 2 (March/April): 64–85.

Asness, C. S., 2000. “Stocks vs. Bonds: Explaining the Equity Risk Premium.”, Financial
Analysts Journal, vol. 56, no. 2 (March/April): 96–113.

Baker, M., Bradley, B., and Wurgler, J., 2011. “Benchmarks as Limits to Arbitrage:
Understanding the Low-Volatile Anomaly.”, Financial Analysts Journal, vol. 67, no. 1.

Barberis, N., and Ming H., 2001. “Mental Accounting, Loss Aversion, and Individual Stock
Returns.”, Journal of Finance, vol. 56, no. 4 (August): 1247–1292.

Benartzi, S., and Thaler, R., 1995. “Myopic Loss Aversion and the Equity Premium Puzzle.”,
Quarterly Journal of Economics, vol. 110, no. 1 (February): 73–92.

Best, M. J., and Grauer, R. R., 1991. “On the sensitivity of mean-variance-efficient portfolios
to changes in asset means: Some analytical and computational results.”. Review of Financial
Studies 4, 315-342.

Black, F. and Litterman, R.. 1990. “Asset Allocation: Combining Investors Views with
Market Equilibrium.”, Fixed Income Research, Goldman Sachs.

Cantaluppi, L., 1999. “The Reverse Optimization.”, Financial Markets and Portfolio
Management.

Campbell, J. Y., and Shiller, R., 1988a. “Stock Prices, Earnings and Expected Dividends.”,
Journal of Finance, vol. 43, no. 3 (July): 661–676.

Chopra, V., and Ziemba, W. T., 1993. “The effects of errors in means, variances, and
covariances on optimal portfolio choice.”, Journal of Portfolio Management pp. 6-11.

Choueifaty, Y., and Coignard, Y., 2008. “Towards Maximum Diversification.”, Journal of
Portfolio Management, Vol. 35, No. 1 (Fall).

Clarke, R., De Silva, H., and Thorley, S., 2012. “Risk Parity, Maximum Diversification, and
Minimum Variance: An Analytic Perspective.”, working paper.

Fama, E. F., and Kenneth, R. F., 1989. “Business Conditions and Expected Returns on Stocks
and Bonds.”, Journal of Financial Economics, vol. 25, no. 1 (November): 23–49.

Frazzini, A., and Lasse, H. P., 2010. “Betting Against Beta.”, Working Paper, AQR Capital
Management, New York University and NBER Working Paper 16601.

He, G., and Litterman, R., 1999. “The Intuition Behind Black-Litterman Model Portfolios.”,
Investment Management Research, Goldman, Sachs & Company.

36
Ibbotson, R. G., and Sinquefield, R. A., 1976a. “Stocks, Bonds, Bills and Inflation: Year-by-
Year Historical Returns (1926–1974).”, Journal of Business, vol. 49, no. 1 (January): 11–47.

Ibbotson, R. G., and Sinquefield, R. A., 1976b. “Stocks, Bonds, Bills, and Inflation:
Simulations of the Future (1976–2000).”, Journal of Business, vol. 49, no. 3 (July): 313–338.

Ilmanen, A., 2011. “Expected returns. An Investor’s Guide to Harvesting Market Rewards”,
Wiley Finance

Jobson, J. D., and Korkie, B., 1980. “Estimation for Markowitz efficient portfolios”, Journal
of the American Statistical Association 75, 544-554.

Markowitz, H. M., 1952. “Portfolio Selection”. The Journal of Finance.

Mandelbrot, B., 1963. “The variation of certain speculative prices”. The Journal of Business.

Meucci, A., 2007. “Risk and Asset Allocation”, Springer Finance.

Meucci, A., 2009. “Managing Diversification”, working paper, symmys.com

Pola, G., 2013. “Managing uncertainty with dams. Assets’ segmentation in response to
macroeconomic changes”, in preparation.

Pola, G., and Facchinato, S., 2013. “Managing uncertainty with dams. Balancing
macroeconomic scenarios”, in preparation.

Rebonato, R, 2008. “Plight of the Fortune Tellers: Why We Need to Manage Financial Risk
Differently”. Princeton, NJ: Princeton University Press.

Reinhart, C. M., Rogoff, K. S., 2011. “From Financial Crash to Debt Crisis”, American
Economic Review, 101: 1676-1706.

37
 Chief Editors:
Pascal Blanqué
Deputy Chief Executive Officer
Head of Institutional Investors and Third Party Distributors
Group Chief Investment Officer
Philippe Ithurbide
Global Head of Research
Assistant Editor: Florence Dumont
Amundi Working Paper

WP-032-2012

November 2012

Written by Amundi.
Amundi is a French joint stock company (société anonyme) with a registered capital of EUR 584,710,755.
An investment management company approved by the French Securities Authority (Autorité des Marchés Financiers -
“AMF”) under No. GP04000036. Registered office: 90, boulevard Pasteur 75015 Paris-France. 437 574 452 RCS Paris.
In each country where they carry on investment business, Amundi and its affiliates are regulated by the local regulatory
authority. This information contained herein is not intended for distribution to, or use by, any person or entity in any
country or jurisdiction where to do so would be contrary to law or regulation or which would subject Amundi or its
affiliates to any registration requirements in these jurisdictions. The information contained herein is produced for
information purposes only and shall not be considered as an investment advice nor the sole basis for the evaluation of
any Amundi’s product. Any data provided herein is based on assumptions and parameters that reflect our good faith
judgment or selection and therefore no guarantee is given as to the accuracy, completeness or reasonableness of any
such data. No examination has been executed by us with respect to the financial, legal, tax, regulatory – and any
related aspects thereof – situation of any addressee of the information here in.

amundi.com