11 of 11 people found the following review helpful
on February 8, 2012
"Historical statistics should not be blindly fed into an optimizer."
This quote summarizes the spirit of this book by Paul D. Kaplan, Ph.D. the Director of Quantitative Analysis at Morningstar. I published a full review of this book here on [..] on February 8, 2012: [..]
Below are some excerpts from this review.
The book covers a wide range of topics that span two decade's of Kaplan's research. The 27 chapters are organized in four sections:
1. Equities (index construction, small-stock betas, etc.)
2. Fixed income, Real Estate, and Alternatives
3. Crashes and Fat Tails
4. Doing Asset Allocation
Markowitz and Optimization
I found Kaplan at his best when discussing asset allocation, the fourth section of the book. He begins with a brief overview of Modern Portfolio Theory, which was based on the 1952 paper by Harry Markowitz. This pioneering work on asset allocation, uncertainty, and diversification led to Modern Portfolio Theory (MPT), and to the efficient frontier, which shows the trade-off between risk and return as a series of optimal portfolios. MPT also led to portfolio optimization, also called Mean Variance Optimization (MVO), and to the "fish hook" charts that adorn many client presentations.
The Limitations of Mean Variance Optimization
Anyone who has worked with portfolio optimization knows that the results are extremely sensitive to the inputs. This leads to "estimation errors," a wonderful euphemism for what could be an investment catastrophe. Consequently, Kaplan emphasizes the importance of the assumptions for expected returns, standard deviation, and the correlation of asset classes. He repeatedly notes that optimizers are extremely sensitive to these assumptions. Kaplan also cautions against cutting our asset class slices too thin: If the asset classes are too similar, high correlations cause the correlation matrix to become "ill-conditioned," and small moves along the efficient frontier result in large changes in asset allocation. Kaplan's work suggests that optimization has limits when used for thin slices of the same wedge, as when stocks are divided into categories such as micro-cap, small-cap, mid-cap, large-cap, and mega-cap.
In chapter 26, Kaplan addresses four key problems with the original Markowitz model, and he offers solutions to each. Kaplan and co-author Sam Savage of Stanford University dub this "Markowitz 2.0," and Harry Markowitz himself approves this nomenclature in an interview (364). Kaplan's discussion of the limitations is unusual, since he actually offers specific solutions. Most critics of Mean Variance Optimization and Modern Portfolio Theory do not go this far, and Kaplan is on solid ground with each of his suggestions.
The Bottom Line
The most critical takeaway I would offer potential readers is this: Paul Kaplan is not only eminently capable and rigorous, but he has intellectual humility and integrity--I trust his judgment and his conclusions.
2 of 3 people found the following review helpful
on January 12, 2013
Paul Kaplan is one of the more innovative thinkers in finance. After leaving Northwestern University Kaplan has spent over two decades at Ibbotson Associates and later Morningstar - after they bought Ibbotson - currently as the research director for Morningstar Europe. Kaplan's thinking spans over almost any topic in finance apart from perhaps individual security selection. Kaplan's eclectic thinking is on full display in this book that collects a number of the author's best papers grouped under a number of headlines.
It's impossible to cover all the topics in the book. However, a few papers stand out. One is "The Long and Short Commodity Indexes" where the author presents a convincing argument that commodity futures' indexes' should be constructed as long-short-indexes instead of normal long-only-indexes. With a rule based trend following long-short strategy the index can reap the benefits of markets that are both in backwardation and in contango. A few texts cover fundamental indexes. One pleasant feature in this book is that a number of papers on the same topic often are rounded up by a debate. A discussion between Kaplan and Robert Arnott of Research Affiliates ends the topic of fundamental indexes. Consensus is reached on that these might be effective strategies as they combine a value reweighting of the index constituents with a flexibility to increase or decrease the bet that is taken versus a market cap weighted index depending on the grade of over- or undervaluation, but they do not represent a new way to define the equity market per se.
Arguably, the most important paper in the book is Markowitz 2.0 (also discussed by Harry Markowitz and Sam Savage with Kaplan as the moderator). The topic is what could be done to update and improve the mean variance optimization framework. The improvements include using the geometric mean of returns, risk measures that better account for the fat tails, using scenario analysis to understand the time varying nature of correlations etc.
My favourite paper however is another one. In fact, it might be one of my favourite papers all time. How often have you heard that asset allocation determine 90 percent of the returns in asset management? In the paper "Does Asset-Allocation Policy Explain 40 Percent, 90 Percent, or 100 Percent of Performance?" Kaplan addresses the fact that most people misunderstand the classic 1986 paper by Brinson et. al. There are actually three questions with three very different answers. The first question is how much of the variability of returns across time in the average fund is ascribed to asset allocation as opposed to security selection? The answer is that asset allocation accounts for 90 percent of the variability in the returns from one year to another for asset managers in general. This is the question Brinson et. al. answered. The second question is how much of the variation between different funds that is explained by asset allocation in a specific year. This is the question most people think Brinson et. al. answered. In Kaplans study the answer is 40 percent and hence security selection accounts for the main difference between competitors a specific year. Finally, the question could be what percent of the returns for the average fund that is explained by asset allocation. As alpha is zero for all participants in the market the answer is obviously 100 percent.
Based on the papers above this is clearly a book that deserves the highest rating. The problem is that some texts are unique and cutting edge, others are fairly plain. Some texts are highly mathematical while others are very short and simple. The book isn't coherent enough.
I highly recommend reading the top five or so of these papers. They are clearly in the forefront of the thinking in asset allocation. If you can't get them in another way, buy the book.
This is a review by eqtbooks.com
2 of 3 people found the following review helpful
on April 10, 2012
This is definitely one of the better investment books I've read on investing.
The book is a series of short essays on various topics compiled in to an easy to read book. It's quantitative (all of the math is explained) but you can easily skip this if you feel like and just read the explanations.