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Contributions by Dan Stefek

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  1. Portfolio managers have long worried that discrepancies between risk and alpha factors may somehow detract from the performance of their optimized portfolios. This paper presents a comprehensive overview of alpha-risk factor alignment and its consequences, showing how penalizing the residual alpha may help reduce the unintended bets resulting from misalignment. However, we also illustrate that correcting for misalignment may not always be necessary and can sometimes be counterproductive—the need for corrective action depends on the information content of residual alpha. Improvement in Information Ratios was achieved in just over half of the cases we examined and the average magnitude of improvement was small.

  2. PAPER

    Research Insight - Manager Crowding and Portfolio Construction - October 2012 

    Oct 10, 2012 Oleg Ruban , Jyh-huei Lee , Jay Yao , Dan Stefek

    Investing (Investment Management) , Portfolio Construction and Optimization , Risk Management

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    Following the “quant meltdown” of August 2007, market observers became concerned that quant strategies were leading to crowded trades. This paper analyzes the impact that a risk model used in portfolio construction has on manager crowding by identifying the drivers of crowding and by illustrating their impact.  A risk model’s effect on manager crowding depends, in part, on how alphas used by different managers are related to each other, and to the risk model factors. We explain how this works with some simple, intuitive examples, and with the aid of a well established analytical framework.

  3. PAPER

    Model Insight - The MSCI Bond Liquidity Measure (BLM) - Sep. 2012 

    Sep 28, 2012 Carlo Acerbi , Zsolt Szekeres , Dan Stefek

    Portfolio Construction and Optimization , Risk Management

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    This Model Insight introduces the MSCI Bond Liquidity Measure (BLM), a model-based estimate of bond bid-ask spreads for a broad universe of quoted and non-quoted bonds. The BLM provides both a liquidity scoring metric and a way to quantify potential transaction costs. Applications of BLM include portfolio construction, risk control, risk limits, regulatory compliance, and liquidity provisioning.  Furthermore, BLM opens the way  for the consistent assessment of liquidity across multi-asset class portfolios.

  4. PAPER

    Research Insight - Is Your Risk Model Letting Your Optimized Portfolio Down? - August 2012 

    Aug 23, 2012 Oleg Ruban , Jyh-huei Lee , Jay Yao , Dan Stefek

    Factor and Risk Modeling , Investing (Investment Management) , Portfolio Construction and Optimization

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    Many portfolio managers use multi-factor models, but not all factor models are equally effective in forecasting risk. Flawed model construction can result in optimized portfolios that are not efficient.  This paper addresses the concern of portfolio managers that some risk models used in optimization may not be forecasting risk accurately, or may be creating suboptimal portfolios. We review pitfalls in portfolio construction and explain how MSCI’s best practices in model building are designed to overcome these challenges.

  5. PAPER

    Model Insight - Barra Private Equity Model (PEQ1) Overview - July 2012 

    Jul 14, 2012 Katalin Varga , Raghu Suryanarayanan , Dan Stefek

    Factor and Risk Modeling , Risk Management

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    Focused on US Buyouts and Ventures, the new Barra Private Equity Model (PEQ1) attributes risk to intuitive public equity and private equity investment type factors, reflects changes in risk in a more timely fashion than traditional methods, and captures the relationship between public and private equity. 

  6. PAPER

    Barra Private Real Estate Model (PRE1) - Research Notes 

    Oct 2, 2011 Raghu Suryanarayanan , Dan Stefek

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  7. PAPER

    Barra Private Real Estate Model (PRE1) - Overview and Highlights 

    Oct 2, 2011 Raghu Suryanarayanan , Dan Stefek

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  8. PAPER

    Mitigating Risk Forecast Biases of Optimized Portfolios 

    Sep 26, 2011 Dan Stefek , Jyh-huei Lee , Jay Yao , Rong Xu

    Portfolio Construction and Optimization

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    Portfolio managers have long suspected that the risk forecast of an optimized portfolio tends to be optimistic. Many have identified the culprit as estimation error in the covariance matrix. Forecasts based on historical asset covariance matrices are particularly sensitive to this error. The bias is reduced dramatically by using a factor model. Even so, factor models still tend to under-forecast the risk of optimized portfolios, especially the risk coming from factors. In this paper, we show how estimation error may lead to under-forecasting the risk of optimized portfolio. The degree of under-forecasting depends on several factors including the investment style of the portfolio as well as the size of the investment universe. We review MSCI’s new Optimization Bias Adjustment for reducing this forecasting bias and illustrate its effectiveness on portfolios tilting on commonly used styles.

  9. PAPER

    Risk Forecast Biases of Optimized Portfolios - A Quantitative Analysis 

    Sep 20, 2011 Dan Stefek , Rong Xu , Jennifer Bender , Jyh-huei Lee , Jay Yao

    Portfolio Construction and Optimization

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    Portfolio managers have long suspected that the risk forecast of an optimized portfolio tends to be optimistic. Many have identified the culprit as estimation error in the covariance matrix. Forecasts based on historical asset covariance matrices are particularly sensitive to this error. The bias is reduced dramatically by using a factor model. Even so, factor models still tend to under-forecast the risk of optimized portfolios, especially the risk coming from factors. In this paper, we show how estimation error may lead to under-forecasting the risk of optimized portfolio. The degree of under-forecasting depends on several factors including the investment style of the portfolio as well as the size of the investment universe. These affects have a  mathematical basis. We quantify them and explain why they occur.  Lastly, we review MSCI’s new Optimization Bias Adjustment for reducing this forecasting bias and illustrate its effectiveness on portfolios tilting on commonly used styles.

  10. PAPER

    Private and Public Real Estate - What is the Link? 

    Jun 16, 2010 Raghu Suryanarayanan , Dan Stefek

    Risk Management

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    In this paper, we study the relationship between private and public real estate in the US and UK markets and demonstrate a strong link between returns in each of these markets. To uncover these relationships, we correct for appraisal smoothing and properly account for the lead-lag relationship between public and private returns. We find that public returns lead private returns, even after removing appraisal smoothing in private returns. We also discuss how real estate risk changes over longer horizons. In particular, our results suggest that private and public returns become more correlated at longer investment horizons. This carries important implications for risk management and strategic asset allocation.

  11. In this study, our goal is to adapt mean-variance optimization to produce active portfolios with less exposure to extreme losses than normal optimized portfolios. Specifically, we illustrate how extreme risk can be incorporated into portfolio construction in a straightforward way by constraining the shortfall beta of the optimal portfolio. Our simple empirical examples suggest that constraining shortfall beta may offer some downside protection in turbulent periods without sacrificing performance over longer periods.

  12. PAPER

    Forecast Risk Bias in Optimized Portfolios 

    Oct 1, 2009 Dan Stefek , Jennifer Bender , Jyh-huei Lee , Jay Yao

    Portfolio Construction and Optimization

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    When there is noise in a covariance matrix, portfolio optimization tends to produce portfolios for which the risk forecasts are underestimates of the true risk. In this paper, we take a closer look at the connection between estimation error and the underestimation of the risk of optimized portfolios. We pay special attention to the case in which returns have a known factor structure. There, the bias in optimization can be reduced dramatically by using a covariance matrix based on a factor model, rather than one computed from historical asset covariances. Moreover, our analysis reveals that for many active portfolios, the bias in factor-model forecasts is less than previously thought. Lastly, we discuss the role of constraints in mitigating risk forecasting bias.

  13. PAPER

    Decomposing the Impact of Portfolio Constraints 

    Aug 1, 2009 Jennifer Bender , Jyh-huei Lee , Dan Stefek

    Portfolio Construction and Optimization

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    This paper analyzes the impact of constraints on portfolio return and risk, extending the insights of previous research in this area. We show that constraints move a manager's portfolio away from the optimal unconstrained portfolio in two ways. First, they may rein in or increase the risk of the portfolio without impairing its information ratio. Second, they may force the portfolio to take unwanted bets that incur risk but yield no return. As a result, a constrained portfolio consists of positions that are aligned with the manager's alphas and positions that are orthogonal to the alphas but are adopted to satisfy the constraints. We illustrate how to measure the risk and return arising from each of these sources and how to drill down to examine the contributions of individual constraints.

  14. PAPER

    Refining Portfolio Construction by Penalizing Residual Alpha - Empirical Examples 

    Jun 1, 2009 Jennifer Bender , Jyh-huei Lee , Dan Stefek

    Portfolio Construction and Optimization

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    Misalignment between alpha and risk factors may create unintended bets in optimized portfolios, as shown analytically in Lee and Stefek (2008).  In a March research insight, we introduced a way to mitigate this issue by penalizing the portion of the alpha not related to the risk factors, the 'residual alpha.' Here, we further illustrate this method with two signals commonly used by portfolio managers. The potential improvement from this method depends on the strategy in question, in particular the degree to which the misalignment of alpha and risk factors erodes information in optimization.

  15. PAPER

    Refining Portfolio Construction When Alphas and Risk Factors Are Misaligned 

    Mar 1, 2009 Jennifer Bender , Jyh-huei Lee , Dan Stefek

    Portfolio Construction and Optimization

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    The misalignment of alpha and risk factors may result in inadvertent and unwanted bets that may hamper performance. Lee and Stefek (2008) show that better aligning risk factors with alpha factors may improve the information ratio of optimized portfolios. They propose four ways of modifying a risk model to reduce misalignment. Here, we discuss one way to mitigate these problems by modifying the optimization process, itself. The objective function is modified to include a penalty term on the residual alpha. In our examples, the method proposed helps to mitigate the mismatch between alpha and risk by assigning a suitable penalty to the residual alpha.

  16. PAPER

    What Does Hedge Fund Ownership Tell Us About Stock Return and Risk? 

    Jan 2, 2009 Jay Yao , Dan Stefek

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  17. PAPER

    Portfolio of Risk Premia: A New Approach to Diversification 

    Jan 1, 2009 Frank Nielsen , Dan Stefek

    Investing (Investment Management)

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    Traditional asset allocation approaches have not provided the full potential of diversification. Here, we introduce a different approach and look at structuring portfolios using risk premia within the traditional asset classes or from systematic trading strategies. We confirm the potential benefits of such an approach by comparing a typical 60/40 equity/fixed income allocation with an equal weighted allocation across eleven risk premia.

  18. PAPER

    Barra Integrated Model - Version 207 (BIM207) 

    Dec 2, 2008 Jose Menchero , Dan Stefek , Peter Shepard

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  19. PAPER

    Do Risk Factors Eat Alphas? 

    Apr 1, 2008 Jyh-huei Lee , Dan Stefek

    Investing (Investment Management)

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    Portfolio managers worry that discrepancies between risk and alpha factors may create unintended biases in their optimized portfolios. We analyze the ramifications of using different factor models of risk and alpha in portfolio optimization and show that aligning risk factors with alpha factors may improve the information ratio of optimized portfolios, even if doing so lowers the overall accuracy of risk forecasts. We discuss ways of modifying a risk model that may help remedy these problems.

  20. PAPER

    Robust Portfolio Optimization: A Closer Look 

    Jun 14, 2006 Jyh-huei Lee , Alexander Zheleznyak , Dan Stefek

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  21. PAPER

    The Barra Integrated Model - Version 204 

    Sep 1, 2005 Dan Stefek , Agnes Hsieh , Fati Hemmati , Anton Puchkov

    Factor and Risk Modeling

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    The Barra Integrated Model (BIM) is a multi-asset class model for forecasting the asset and portfolio level risk of global equities, bonds, currencies, and commodities. The model uses innovative methods to couple broad asset coverage with the detailed analysis of Barra's models that focus on particular markets. This makes it suitable for a wide range of investment purposes, from conducting an in-depth analysis of a single-country portfolio to understanding the risk profile of a broad set of international investments.

  22. PAPER

    The Barra Integrated Model - Part 2 

    Jan 1, 2003 Dan Stefek

    Factor and Risk Modeling

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    In the Autumn 2002 edition of Horizon, we introduced our new framework for global risk analysis, the Barra Integrated Model. This multi asset class framework was developed with two goals in mind: breadth of coverage and in-depth analysis. Risk analysis using the Integrated Model allows investment professionals to capture the detail available with local market models while retaining the broad perspective of a global, multi asset class model. To achieve these objectives, we first built models for three separate asset classes: global equities, global bonds and currencies.  The general methodology for constructing these models was described in Part One. In this article, we more fully specify the structure for each asset class.

  23. PAPER

    The Barra Integrated Model - Part 1 

    Jan 1, 2002 Dan Stefek

    Factor and Risk Modeling

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    Barra has recently released the Barra Integrated Model, a multi-asset class model for forecasting the asset and portfolio level risk of global equities, bonds, and currencies. The model uses innovative methods to couple broad asset coverage with the detailed analysis of Barra's models that focus on particular markets. This makes it suitable for a wide range of investment purposes, from conducting an in-depth analysis of a single-country portfolio to understanding the risk profile of a broad set of international investments. This article introduces the general modeling framework and methodology used to construct the Integrated Model. We first give an overview of our aims and approach. We then describe the common basic structure used to build two components of the Integrated Model – a global equity and a global bond model. Future articles will expand on these global asset-class models and describe how they are integrated.

  24. PAPER

    The Barra Integrated Model 

    Jan 1, 2002 Dan Stefek

    Factor and Risk Modeling

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    The Barra Integrated Model is a multi-asset class model for forecasting the asset and portfolio level risk of global equities, bonds and currencies. The model uses innovative methods to couple broad asset coverage with the detailed analysis of Barra's models that focus on particular markets. This makes it suitable for a wide range of investment purposes, from conducting an in-depth analysis of a single-country portfolio to understanding the risk profile of a broad set of international investments.  This paper describes the methodology and construction of the model. First we give an overview of our aims and approach. We then describe the common basic structure we use to build the global asset-class models, and look at the application of this structure to equities and bonds. Lastly, we describe how currencies are modeled and provide a detailed look at how we combine all the components to generate the full Barra Integrated Model.

  25. PAPER

    The Barra Integrated Model 

    Jan 1, 2002 Dan Stefek

    Factor and Risk Modeling

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    The Barra Integrated Model is a multi-asset class model for forecasting the asset and portfolio level risk of global equities, bonds and currencies.  The model uses innovative methods to couple broad asset coverage with the detailed analysis of Barra's models that focus on particular markets.  This makes it suitable for a wide range of investment purposes, from conducting an in-depth analysis of a single-country portfolio to understanding the risk profile of a broad set of international investments.

  26. PAPER

    Global Factors: Fact or Fiction? 

    Sep 1, 1989 Richard Grinold , Dan Stefek , Andrew Rudd

    Factor and Risk Modeling

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    The authors of this article view the international equity market through the lens of a multiple-factor risk model.  They find that the most important attribute of a company is its country. Industry is also important. Industries linked by commodity prices and markets (energy, banks, casualty insurance, and metals) are more significant than unconnected industries (consumer goods). The importance of industries has not increased from 1983 through 1988.

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