CHAPTER 6: APPLICATION OF PORTFOLIO THEORY
6.4 INCLUSION OF ART INVESTMENTS
6.4.3 Analysis of the assets used in the construction of the portfolios
This section will concentrate on performance analysis and risk analysis of the individual assets, a later section will also consider the degree of co-movement that exists between the various assets.
6.4.3.1 Performance analysis
Figure 6.31 illustrates the annual index movements of the ALBI during the period ranging between 1989 and 2002.
Figure 6.31
All Bond Index Movements
Source: Inet
From figure 6.31 it appears that the index level increased over the holding period, but it tended to fluctuate between a level of 115 and 165.
Figure 6.32 illustrates the index movements of the All Share Index over a corresponding holding period.
Figure 6.32
All Share Index Movements
Source: Inet
Figure 6.32 indicates the ALSI index increase during the holding period from a level of about 2800 to a level of about 9500.
Figure 6.33 plots the annual BA-rate over a holding period which is concurrent with that of the previous two assets.
Figure 6.33 Annual BA-rates
Source: Inet
Figure 6.33 indicates that the 90day BA yield-rate has declined during the holding period. This downward movement should not be seen in isolation and should be considered on a portfolio wide basis.
Lastly figure 6.34 illustrates the annual movements of the Fine Art Index (FAI) during the holding period.
Figure 6.34
Annual movements of the FAI
Source: Inet
From figure 6.34 it appears that the FAI has increased during the holding period that ranges from 1989 to 2002.
Even though the figures listed above allow investors to make certain initial conclusions, these conclusions are normally relatively limited. In order to be able to directly compare the results indicated by these graphs the figures need to be standardized. The following section will standardize these figures via the use of the holding period yield calculation.
The holding period yield movements for the debt investments are illustrated in figure 6.35.
Figure 6.35
HPY movements of the ALBI
Source: Inet
From figure 6.35 it appears that the HPY on the ALBI ranged between –0.2%
return per annum to +0.15% per annum. Also the figure indicates that at times the HPY experienced swings between positive and negative returns.
Figure 6.36 illustrates the HPY movements for the equity investment (ALSI) over the holding period.
Figure 6.36
HPY movements of the ALSI
Source: Inet
From figure 6.36 it appears that the HPY on the equity investment ranged between -0.1% per annum and +0.65% per annum. This wider range of movements should lead the investor to believe that the equity asset was more risky than the debt investment. This is in line with the conclusions made in previous sections of this study.
The HPY movements for the cash investment (BA) are plotted in figure 6.37.
Figure 6.37 HPY of the BA
Source: Inet
Lastly figure 6.38 graphically illustrates the HPY movements of the art investment (FAI).
Figure 6.38 HPY of the FAI
Source: Inet
From the figure it appears that the HPY on the FAI ranged between the levels of –0.35% and +0.32% per annum. This should lead one to believe that the art investment was less risky than the equity investments.
From the data used to construct the figures used above, one would be able to derive the following table (table 6.13)
Table 6.13
Table of comparative performance measures
Asset Simple Average
HPY
Annualized HPY
Debt 3.27% 2.53%
Equity 12.29% 9.28%
Cash 14.08% 14.08%
Art Investment 3.19% 1.50%
Source: Inet
From table 6.13 it appears that the cash investment generated the highest level of return during the holding period, whilst the art investment generated the lowest overall return during the holding period.
6.4.3.2 Risk analysis
As was the case in the previous analyses, the assets should be analysed in terms of both risk and return. This section will consider the risk characteristics of the assets being analysed.
Again the probability distributions of the returns on the assets will be used to provide a visual reflection of the dispersion of returns around a mean value. It should be noted that higher levels of dispersion indicate higher levels of risk.
Figure 6.39
Probability distributions of assets
Source: Inet
Figure 6.39 illustrates the probability distributions of each of the assets (the graphs were drawn on the same scale). From this it seems that the ALSI proved to be the riskiest of all the assets, whilst cash was the least risky of the
assets. The FAI was more risky than the ALBI and cash, but less risky than the ALSI.
The following table (table 6.14) tabulates the numerical values of the assets percentage annual volatility.
Table 6.14
Percentage Annual Volatility Percentage Annual Volatility ALBI 10.65%
ALSI 24.73%
Cash 3.13%
Art 17.88%
Source: Inet
Table 6.14 confirms the results of the visual inspection performed above.
From the table one would be able to deduce that the ALSI was in fact the riskiest of the assets over the holding period and cash the least risky of the assets.
6.4.4 Portfolio construction
Following the analysis of the individual assets the study focuses on constructing portfolios which consist of combinations of the assets analysed above.
This section will consider the relationships between the assets that are to be included in the subsequent portfolios. Secondly the section will aim to construct a diversified portfolio consisting out of a mixture of debt, equity and cash. Lastly the section will aim to consider the effects of the inclusion of the
art investment in the diversified portfolio. It should be noted that this new portfolio will be labelled the “art portfolio”.
6.4.4.1 Construction of the diversified portfolio
Prior to the actual construction of the portfolio consideration should be given to the relationships that exist between the price movements of the different assets. Figure 6.40 illustrates a scatter plot matrix of the relationships between the different asset returns.
Figure 6.40
Scatter plot matrix of asset returns
Source: Inet
From figure 6.40 it would seem as if there is a positive relationship between the returns on the ALBI and the ALSI, as well as between the returns on the
and cash are decidedly negative. There seems to be a negative relationship between the returns on the ALSI and the FAI, whilst there is a small negative relationship between the returns on cash and the FAI.
From the data used to construct the scatter matrix the following correlation co-efficient matrix may be derived.
Table 6.15
Correlation coefficient matrix of asset returns
Debt Equity Cash Art
Debt 1
Equity 0.2292 1
Cash -0.4115 -0.5063 1
Art 0.1836 -0.2233 -0.0268 1
Source: Inet
From table 6.15 it seems that the negative relationships that exist between the returns of the cash asset and the debt instrument, the equity investment and the cash asset as well as the equity investment and the art investment hold the promise of enhanced diversification of portfolios.
Using the various findings of prior sections an efficient frontier may now be derived for the diversified portfolio. Figure 6.41 illustrates this efficient frontier.
Figure 6.41
Efficient frontier for the diversified portfolio
Source:Inet
As was the case in the previous sections the assumption is made that an investor will target the minimum variance portfolio, i.e. that portfolio with the lowest level of risk. Following the selection process the asset mix for the minimum variance portfolio is illustrated in figure 6.42.
Figure 6.42
Asset mix of the diversified portfolio
Source: Inet
This asset mix would have presented the investor with a return of 7.28% and a level of risk equal to 7.87% as measured by standard deviation.
6.4.4.2 Construction of the art portfolio
This section will aim to analyse the benefits, or lack thereof, of including the art investment in the diversified portfolio. From the previous calculations the following efficient frontier (as illustrated in figure 6.43) may be constructed for the art portfolio.
Figure 6.43
Efficient frontier for the art portfolio
Source:Inet
From figure 6.43 it would seem as if the inclusion of the art investment in the diversified portfolio would have had an effect on the risk and return of the diversified portfolio.
Again the assumption is made that investors will target the minimum variance portfolio. This strategy would have resulted in an asset mix as indicated in figure 6.44.
Figure 6.44
Asset mix of the art portfolio
Source: Inet
Based on the above-mentioned asset mix the relevant portfolio statistics may be calculated. These statistics are presented in Table 6.16 below.
Table 6.16
Portfolio statistics of the diversified portfolio and the art portfolio Diversified
portfolio
Art portfolio
Return 7.28%% 11.70%
Standard Deviation 7.87%. 2.37%
Source: Inet
From table 6.16 it appears that the inclusion of the art investment in the diversified portfolio resulted in an increase in the level of return, as well as a decrease in the level of risk of the portfolio, as measured by standard deviation.
The conclusion that may be drawn from this analysis is that the inclusion of the art investment in the diversified portfolio would have benefited the holder of the portfolio during the holding period, reviewed in this study.
6.5 SUMMARY
This chapter applied the theoretical principals of portfolio construction to three alternative assets, that being wine, art and gold coins.
The experiments started off by establishing a ‘traditional’ diversified portfolio consisting of a mixture of cash, bond and stocks. This portfolio then served as a proxy for a completely diversified portfolio (the market portfolio as identified in the discussion on modern portfolio theories). Following the construction of this proxy portfolio, the effects of including a single alternative asset to the existing asset-mix was considered.
The alternative assets used for the purposes of this chapter included Kruger Rands (gold coins), 1982 Mouton Rothschild and 1982 Montrose (wine), and a art investment based on an art index. These assets were chosen on the basis of the availability of historic price information.
Each of the experiments performed during this chapter indicated that these assets had a positive impact on both the risk and return characteristics of the proxy portfolio. In most instances return increased, whilst overall risk decreased. These results stem mainly from the low positive and negative correlations that these assets had with the assets used in the proxy portfolio.
Upon considering the results obtained from these experiments it followed that investors may benefit from considering some of these alternative investments when constructing diversified portfolios. It should however be noted that investors are urged to take a medium to long-term view on these assets.
CHAPTER 7: CONCLUSION
This section will discuss the various conclusions that may be made following the completion of the study.
• At the outset of the study the aim was to determine whether or not alternative/hard assets might be used to diversify existing portfolios even further. The study commenced with a brief overview of various modern portfolio theories and their respective origins, then the study moved on to discuss in detail the subjects of risk and return, including their respective methods of measurements. From there the focus of the study moved to the identification of various alternative assets. The next section of the study gave consideration to the theories surrounding efficient markets and the efficient market hypothesis. This formed the theoretical basis for the study.
• The last section of the study concentrated on producing and investigating empirical evidence which would confirm or reject any initial assumptions made during the early stages of the study.
The following section will briefly consider some of the most prominent findings of each of the chapters and the study as a whole.
After considering the various portfolio theories, including the Markowitz portfolio theory and the Capital Market Theory, the conclusion was reached that the methods used, within these theories to construct diversified portfolios, would be directly applicable to this study. More specifically this decision was made to use the Markowitz Portfolio Theory as the basis for this study in light of the fact that the Capital Market Theory is an extension of the Markowitz Portfolio Theory and as such the findings of the study should not be significantly different if the portfolios were constructed by using the CMT.
From this initial study followed the close examination of various concepts
The study investigated more closely, the most important features of the different portfolio theories. This included an in depth look at the definitions and measurement of both risk and return. The section identified standard deviation, as used in the Markowitz portfolio theory, as the relevant measure for risk. In keeping with this it was decided to construct consequent portfolios along the guidelines set out by the Markowitz portfolio theory.
The study concentrated on the identification and discussion of various alternative investments/assets. These assets included assets such as furniture, art, investment cars, containers and ceramics. Each asset or asset class was briefly reviewed. The main contribution of this study, apart from identifying various assets, was the identification of those factors which may be regarded as universal value drivers of these assets. Among these factors were authenticity, quality and provenance. Upon completion of the investigation into the various assets it became apparent that even though there were various alternative assets available for inclusion into portfolios, some assets were more prominent than others. The most significant assets as identified by the study included Gold, Wine and Art. The study also provides a framework for the classification of assets into one of four groups, those groups being antiques, collectibles, art and general alternative investments.
The identification of the more prominent alternative assets, as mentioned above, led to the investigation of the effects that these assets would have on existing portfolios. It should be noted that these assets were identified based on the availability of price data and information relating to the assets.
Even though the main aim of the study was not to investigate the efficiency of the alternative asset markets, as the study progressed it became apparent that a brief discussion of this subject was warranted. The study gave consideration to the various characteristics of good markets as well as to the different forms of the efficient market hypothesis (EMH). Upon conclusion of the initial examination various markets were tested in broad terms, against the characteristics identified. These markets included equity markets, bond
findings of this section of the study are considered to be significant as it would appear that most alternative markets subscribed to the weak-form of the EMH. This would lead investors to believe that they should be able to derive above average risk-adjusted returns, based on superior information, or access to information regarding the asset. The study indicated that one of the major disadvantages of alternative asset markets were their informational inefficiency. This section was also identified as one that holds promise for further investigation on the subject matter of alternative investments.
The findings of this empirical seemed to be important given the goal of the study. During the course of this section of the study, the researcher performed an analysis of those alternative assets which were perceived to be the prominent groups/assets.
What is important, and this warrants the study as a whole, is the fact that the inclusion of an alternative asset into an existing portfolio (assumed to be a fully diversified portfolio, given various assumptions) gave rise to a greater or lesser extent, to improved diversification and return. The results of the study reject the hypothesis that these investments do not hold any benefits in terms of further diversification of diversified portfolios.
Throughout the study it becomes apparent that alternative investments/hard assets hold untapped potential for improving the risk/return characteristics of existing investment portfolios. The study identified various benefits and constraints associated with investing in these assets. It should be noted that no asset class is without constraint or disadvantage and therefore investors should not exclude the possibility of including an alternative asset into their existing portfolios (taking note of constraints and giving it the necessary consideration).