HMC’s method of portfolio allocation consist of:
- using the CAPM model to make long term assumptions about real return, risk, and correlations of the twelve asset classes it has created and
- using the Mean Variance Optimization method (MVO) to find the set of portfolios that would provide the maximum expected return for a given level of risk and, conversely, the minimum risk for a given level of expected return (“the efficient frontier” of possible combinations of asset classes).
To infer variance and covariance of each asset class and estimate all the necessary parameters for the CAPM, HMC examines historical data, asks the opinion of consultants and investment management firms and uses the current market conditions to adjust its assumptions. As the true values are unknown, it is easy to make mistakes that will impact the MVO, which has the disadvantage of being very sensitive to changes in its inputs (small changes cause significant output movement and can result in having an inefficient portfolio).
As emphasized in Exhibit 11, we note that HMC, given approximately the same level of risk, has the same expectation for domestic and foreign real returns. This implies that the equity risk premium (E(ri)-rf ) for both asset classes is the same. It suggests that HMC has the same risk aversion when it comes to invest in a foreign asset or a domestic one, it expects the markets to evolve similarly.
Due to its simplicity of utilization, The MVO method is very attractive for investor. Using a software as simple as Microsoft Excel and its Solver, the efficient portfolio allocation between classes can be computed in a few minutes. The logic behind the model is really simple: investors hate risk (volatility) and love returns. However, as stated above, it has its limitations: It only take into account the first two moments and disregard the others, it doesn’t explain