You are on page 1of 35

International Review of Financial Analysis Manuscript Draft Manuscript Number: FINANA-D-08-00061R2 Title: The effect of Downside Risk Reduction

on UK Equity Portfolios included with Managed futures funds Article Type: Full Length Article Keywords: Downside Risk, Value-at-risk, Lower Partial Moment, portfolio Diversification Abstract: The concept of asymmetric risk estimation has become more widely applied in risk management in recent years with the increased use of Value-at-risk (VaR) methodologies. This paper uses the n-degree lower partial moment (LPM) models, of which VaR is a special case, to empirically analyse the effect of downside risk reduction on UK portfolio diversification and returns. Data on the diversified Managed Futures funds are used to replicate the increasingly popular preference of investors for hedge funds and fund-of-funds type investments in the UK equity portfolios. The result indicates, however that the potential benefits of fund diversification may deteriorate following reductions in downside risk tolerance levels. These results appear to reinforce the importance of risk (tolerance) perception, particularly downside risk, when making decisions to include managed futures funds in UK equity portfolios as the empirical analysis suggests that this could significantly negatively affect portfolio returns.

Detailed Response to Reviewers

Reviewer #1: The paper is currently not ready to be published. It really needs to have an editor go through and work on sentence structure and tense. I have made a large number of edits but it really needs a professional editor. The previous version of the paper had considered the comments from the reviewer, which was also found within the previous version of the paper. In this current version of the paper, I further tidy up my amendments made and I also revised the Abstract, to make it reflect the theme of the paper more directly. An editor was also engaged to help with sentence constructions and tenses to help bring out the ideas of the paper sharper and clearer. I hope the ideas now flow better and more smoothly and help this revised paper to read better In Table 3, the results are a bit shaky because securities with positive skewness have their allocations decrease as n increases. Securities with negative skewness have their allocations increase as n increases. The portfolio skewness increases appropriately as n increases but the securities should be consistent with the portfolio skewness. This doesn't make sense. Are you sure you are deriving the skewness from the Jarque-Bera test correctly? Why don't you just compute skewness directly as the third moment divided by the standard deviation cubed? I think you need to deal with this result. Table 3 was a bit confusing in the earlier version of the paper. All information, except security skewness, is related to out sample. In the current revised version of the paper, I replace in sample skewness in table 3 with out-sample skewness, I hope this will enhance clarity of the information in table 3. Table 3 now shows that LPM4 portfolios skewness increase to 0.4 is partly because it has a 80% allocations with German Stock, which has a significant positive skewness of 0.4785 out sample. Therefore, now we can see that the portfolio skewness increases appropriately as n increases and also showing evidence that it is consistent with the securitys skewness. However, securitys skewness only partly explains the portfolio out sample performance. CLPM (shown in table 4) of Germany index with other allocated assets were also discussed in the revised text in support of the portfolio performance found in table 3. To prevent confusion and to be consistent, I also amended table 4 to have only out-sample CLPM values, similar to table 3, which now only has out-sample related performance information. These are mentioned and discussed in discussion of results in this current revised version of the paper.

In addition, my original comment # 3 wasn't really dealt with. There is only one set of results in Table 3 - please explain the origin of these results. I should explain it clearly now how I deal with this comment. I mentioned that I made some
n

slight errors previously in the way I present the notation in equation (7). So,
n

rj x j

was

corrected to

rj x j

from above was the expected return. This is based on the historical in sample returns. The optimisation program we run allow for the flexibility to choose = or inequalities signs such as in the constraints shown in equation 7. We selected in the constraints, to imply that all asset allocated must have portfolio returns at least equal to the average of individual assets historical in sample returns. Another advantage of using rather than = in the constraint is that. This allows more flexibility in the iteration process and gives degree of freedom to help convergence with a unique solution set more efficiently. I dont think what we do is unusual, because some recent papers such as Moreno, D., Marco, P., Olmeda, I (2005) (Risk Forecasting models and optimal portfolio selection in Applied Economics, pg 1270) appears to have applied similar algorithm, when dealing with optimisation constraints similar to ours. I hope this gives some ideas how we derive the results in table 3 and hopefully also explain the origin of the results. Otherwise, the paper looks like it is in pretty good shape academically. Just go through it and look at my comments and edits. I added two more references and suggest some footnotes. I don't think the current fad of bootstrapping is required for this paper as I haven't seen it change any results.

Main Text Click here to view linked References

The effect of Downside Risk Reduction on UK Equity Portfolios included with Managed Futures Funds

Kai-Hong Tee

Abstract

The concept of asymmetric risk estimation has become more widely applied in risk management in recent years with the increased use of Value-at-risk (VaR) methodologies. This paper uses the n-degree lower partial moment (LPM) models, of which VaR is a special case, to empirically analyse the effect of downside risk reduction on UK portfolio diversification and returns. Data on the diversified Managed Futures funds are used to replicate the increasingly popular preference of investors for hedge funds and fund-of-funds type investments in the UK equity portfolios. The result indicates, however that the potential benefits of fund diversification may deteriorate following reductions in downside risk tolerance levels. These results appear to reinforce the importance of risk (tolerance) perception, particularly downside risk, when making decisions to include managed futures funds in UK equity portfolios as the empirical analysis suggests that this could significantly negatively affect portfolio returns.

Keywords: Downside Risk, Value-at-risk, Lower Partial Moment, Portfolio Diversification


JEL Classification numbers: G15 G11

The effect of Downside Risk Reduction on UK Equity Portfolios included with Managed Futures Funds

1. Introduction

Academic and practitioner interest in asymmetric risk analysis, in particular relating to the Lower Partial Moment (thereafter, LPM) and the development of practical applications of Value-at-risk1 (thereafter, VaR) methodologies, has greatly increased in recent years. For example, research by Danielsson et al (2006) and Hyung and de Vries (2005) have related VaR to the lower partial moments of return distributions. The initial academic interest in LPM can in fact be traced back to Markowitzs (1952) seminal paper on portfolio diversification. However, due to the combination of computational costs and the success of his mean-variance framework, Markowitzs insights into the LPM were largely ignored over the subsequent 40 years. With the development of information technology and the limitations of the meanvariance framework becoming more apparent, these constraints no longer apply and hence interest in developing LPM methods has greatly increased. Even so, to date this work has tended not to focus on how the LPM can flexibly capture varying degrees of risk tolerance and their implications in respect of portfolio allocation problems, which is the primary focus of this paper. The purpose of the current paper is to first review and discuss the risk measures related to LPM, its development and the relationship to the currently used VaR model and second to empirically evaluate from a UK investor perspective the practical implications in terms of portfolio performance. The empirical evaluation of these issues from a UK investor perspective
1

See Jorion (2002) for an overview of Value-at-Risk concepts and applications.

provides the first indication regarding how LPM can be utilised to effect downside risk reduction of portfolio returns and diversification. The paper is structured as follows. In Section two, the paper reviews the literature dealing with the rationale, structure and development of the LPM model. Section three discusses the empirical objective of the study and the data and research method used. Section four presents and discusses the main findings, and section five summarises the results and discusses their implications.

Literature Review

2.1

Risk Measures of Variance and Below-Target Variance

Since the publication of Markowitzs (1952) seminal paper on portfolio diversification, there have been numerous subsequent studies on portfolio selection and performance, the overwhelming majority of which have focused exclusively upon the first two moments of return distributions: the mean and variance.

The concept of downside risk was first systematically analysed by Markowitz (1959) where he recognises that analyses based on variance assume that investors are equally anxious to eliminate both extremes of the return distribution. Markowitz (1959) suggested however that this does not accurately reflect investor preferences for minimising possible losses and that, therefore, analyses based on the semi variance, which assumes that investors primary decision criterion is on reducing losses below target mean returns, could provide a more accurate model of investor decision making. By concentrating on minimising portfolio losses below some target mean

returns, this type of analysis produces portfolio allocations that minimise the probability of below target means returns2.

According to Nawrocki (1999), Markowitz (1959) provides two suggestions for measuring downside risk: a semi-variance computed from the mean return or below-mean semi variance (SVm) and a semi variance computed from a target return or below-target semi variance (SVt). The two measures compute variance using the returns below the mean return (SVm) or below a target return (SVt). Since only a subset of the return distribution is used, Markowitz called them partial or semivariances and their computation is as follows:

SVm

1 k
1 k

[ Max(0, ( E
i 1
k

RT )] 2

below-mean semi variance

(1)

SVt

[ Max(0, (t
i 1

RT )] 2

below-target semi variance

(2)

Where RT is the asset return during time period T, k is the number of observations, t is the target rate of return and E is the expected mean return of the asset being considered. Max indicates that the formula will square the greater of the two values, 0, or (t RT).

Nawrocki (1999) and Harlow (1991) discuss the development and research of both below target and below mean semi-variances and emphasize that one of the most enduring and related ideas involve focusing on the tail of the relevant distribution of
2

However, due to the complexity and the costs involved in the computation of semi-variance analyses, especially so when such analysis can only be undertaken iteratively, Markowitz (1959) choose not to pursue this line of inquiry. He rejected the semi-variance as the preferred risk measure and concentrated instead on his now famous mean-variance approach to portfolio theory. Even so, Markowitz (1959, p. 194) commented that the superiority of variance with respect to computational and other costs, convenience and familiarity do not, and may not in the future, preclude the use of semi-variance.

returns, i.e., the returns below some specific threshold level or target rate. Risk measures of this type are referred to as Lower Partial Moments (LPM) because only the left-hand tail (i.e., probability of under-achieving a threshold return) of the return distribution is used in calculating risk. LPM may sometimes reveal the extent3 of skewness, but it cannot be identified as the third moment (skewness) since skewness4 assumes variance as the primary risk measure while LPM assumes variation of below-target return as the risk measure.

2.2

Lower Partial Moment and the relation to Value-at-risk

Nawrocki (1999) observes that the research and subsequent development of downside risk measures and LPM only really progressed following the publication of the Bawa (1975) and Fishburn (1977) studies which described the LPM as belowtarget risk in terms of risk tolerance. Given an investor risk tolerance value n, the general measure, the lower partial moment, was defined as follows.

LPM (n, t)

1 k

[ Max(0, (t
i 1

RT )] n

(3)

Skewness measures the concentration of return distributions surrounding the mean values. LPM, however, measures the deviations of return below a certain target rate, which may not necessarily be the mean value. 4 To illustrate their differences, consider a portfolio selection problem with skewness that adopts the Polynomial Goal programming (PGP) method for optimisation, see Lai (1991), Chunhachinda, et al (1997) and Prakash, et al (2003) for more details. In constructing the optimisation, the standard statistical moment of distributions, where investors exhibit a preference for higher values of odd moments (mean return, skewness) and a dislike for higher values of the even moments (variance, kurtosis) (see Scott and Horvath 1980), are incorporated. Here, multiple objectives related to the three moments are defined, i.e., to maximize expected rate of return, minimize variance and maximize skewness and solved by PGF. Unlike the LPM method, the optimisation algorithm of PGP solved the portfolio selection problem (with skewness) assuming variance as a risk measure. In this case, skewness, together with the other two moments, is used to reflect the attitude towards both the upper and the lower part of the distribution. In the case of LPM, the optimisation algorithm solved the portfolio selection problem by the minimisation of the variation below the assets return target level, which is defined as the risk measure.

Where k is the number of observations, t is the target return5, RT is the return for the asset during time period T and n is the degree of the lower partial moment. It is the n value that differentiates the LPM from the Semi-variance models (in equation (1) and (2)), which restricted n to be equal to 2. The value of n is viewed as the weights that are placed on the tolerance for the below-target variation. The higher the n values, the more the investor is risk-averse with respect to below the target returns

Equation (3) implies that investors are not likely to be risk averse throughout the full range of the return distribution and will exhibit risk-averse behaviour or be risk neutral depending on the target returns, since the target return should differentiate and determine the preferred gain and the corresponding risk tolerance. The Lower Partial Moment model of equation (3) does not capture investors preference on the derivation above the target rate returns. It assumes investors to be risk neutral for any returns above the target rate. This means that investors are indifferent with the range of returns, as long as they are above the target rate. For below target returns, investors exhibit risk averse behaviour, i.e., they are keen to minimise the deviation between the actual and the target rate of returns. The utility function underlying the lower partial moment model therefore assumes an asymmetric pattern differentiating the below target and above target rate returns (see, Fishburn, 1977 for additional details).

Bawa (1975) defines LPM as a general family of below-target risk measures, one of which is the below-target mean semi-variance, that was discussed in Markowitz (1959) and described by equation (1). Fishburn (1977) regards this as
5

The target value is normally assumed to be zero. Depending on how target rate is to be defined, alternatively, risk free rate can also be used as target return.

simply a special case and argues that the flexible n-degree LPM allows different values of n to be approximated, which implies a variety of attitudes towards the risks of falling below a certain target level of returns. According to Fishburn (1977), n < 1 when investors seek to add additional risk to a portfolio; where n > 1 investors are risk averse to below target returns. Fishburn (1977) and Nawrocki (1992) argue that the LPM algorithm is general enough for it to be tailored to the utility function of individual investors. Conceptually at least, an n-degree LPM algorithm such as equation (3) should provide scope for Stochastic Dominance analysis given that the Second degree stochastic dominance (SSD) also includes all LPM utility functions where n > 1. Furthermore, there are also no restrictive assumptions about the probability distribution of security rates of return6 underlying the n-degrees LPM model.

Guthuff et al (1997) explain how Value-at-risk (VaR) can be transformed into the LPM at n=07. Comparing the various risk measures, Kaplanski and Kroll (2001) note that VaR can be differentiated from the Fishburn n-degree risk measures. However, like the other below-target-returns risk measures, the VaR measure accounts for risk as being below a fixed reference point. VaR, in this case, is different from Fishburns n degree measurement of risk because the latter weighs all the results below a fixed reference point t. However, VaR measures risk or the maximum potential loss assuming this loss has a confidence interval of 1 P. (where P is defined as one of the lower quantiles of the distribution of returns that is only exceeded by a certain percentage such as 1%, 5%, or 10%). Hence, VaR considers

This means, despite the distributional characteristics or the probability distribution of the security returns, they are transformed to capture the upside and downside returns by the LPM optimisation algorithm in equation (3). 7 Appendix 1 further illustrates this point.

risk as one potential loss with a cumulative probability of occurrence of 1 P, while ignoring both larger and smaller potential losses, involving a target rate.

While Guthuff et al (1997) have explained how VaR is related to and a special case of LPM at n=0, this nevertheless reveals the relatively restrictive scope of VaR in explaining risk tolerance levels. Nevertheless, it supports the argument of Fishburn (1977) that LPM provides a general model encompassing utility functions of various forms and patterns. Indeed, it is shown analytically in the Appendix that VaR is part of the LPM family and that LPM at n=0 assumes a normal distribution. Thus at n=0, normality is imposed on the distributional pattern of securities returns. The scope and practicability of VaR therefore becomes somewhat limited when compared to the ndegree LPM models. These conditions are even more restrictive when applied to assets whose returns are skewed, as is the case in our empirical study. This is the primary reason why it is only appropriate to consider LPM of n analysis8. 1 in our portfolio

2.3

Lower partial moment and the relation to the co-lower partial moment

Research in the area of applying LPM models to asset allocation problems is fairly limited, and especially so when including the degree of risk tolerance to the allocation problem. Nawrocki (1992) provides one of the few examples of research in this area He investigates two topics in relation to LPM theory: namely, the size and

Additionally, Value-at-Risk (VaR) or more precisely LPM at n=0 that defines the maximum potential loss to an investment with a pre-specified confidence level, also has risk coherence issue when solved in a portfolio optimisation problem. Addressing these issues is beyond the scope of this paper. See Acerbi & Tssche (2001) and Artzner, et, al (1999) for more discussion and details.

composition of portfolios selected by an n-degree LPM algorithm, and the effect of varying downside risk tolerance on the performance of investment portfolios.

Nawrocki (1991) describes a methodology for modelling co-lower partial moment (CLPM). CLPM incorporates the relationship or interactions of the underlying two assets lower partial moment. This involves, firstly, the calculation of the semi-deviation (SD) as follows:

SDni

1 m

[ Max(0, h Rit )] n }1 / n
t 1

(5)

where h is the target return, m is the number of observations, n is the LPM degree, which is non-negative and SDni is the semi deviation for security i for the period n. SD is included in the CLPM9 computations as follows:

CLPM

( SDni )( SDnj )( rij )

(6)

where r is the correlation coefficient between securities i and j, SDni and SDnj are the semi deviations for security i and j for the period n.

This paper adopts the methodology for modelling CLPM used in Nawrocki (1991) and Nawrocki (1992). Similar applications of the methodology can also be found in recent research such as Moreno et al (2005). Section 3 provides a more detailed discussion of the methodology adopted by this paper.

This method used to compute the CLPM is also known as the Symmetrical CLPM approach. According to Nawrocki (1991), Elton et al (1978) provide the motivation for using the Symmetrical CLPM. They show that a simple algorithm like this can provide better forecast than a complex optimal algorithm. The Nawrocki (1991)s approach to formulate the symmetrical CLPM gives positive semi-definite matrix, which is an important property for solving an optimisation problem.

An Empirical Study

3.1

Data

The aim of this paper is to conduct an empirical study using the n-degree LPM models for asset allocation problems in a manner similar to that of Nawrocki (1992). However, in this paper the time period of the empirical study is updated and covers the period from 199910 to 2006. In this study, both equity data and Managed Futures Funds11 data are used to reflect the increasingly popular investment strategies that include fund-of-funds type investments in equity portfolios, such as fund of hedge funds. Furthermore, Managed Futures also often exhibit positive skewness12 distributional characteristics and this suits the application of the n-degree LPM models13, an application that is seldom seen in the academic literature.

Our study uses the monthly MSCI stock return data for: the USA, Japan, Germany, France, Switzerland, Canada and the United Kingdom, accessible from DataStream International and are value weighted14. We convert returns into UK

10

The reason to start from 1999 is because France and Germany begin using euros from 1999. This helps reduce problems on currency conversion 11 A survey by Eurohedge (see www.eurohedge.com), a trade publication for the European Hedge fund community, shows an annual mid-year (i.e. as at 30th June 2004) total of $216 billion of assets under management by the European hedge fund community, an increase of over 70% from $125 billion at the end of June 2003 and more than 25% above the $168 billion estimated to have been invested at the start of the year, January 2004. Managed Futures funds are also a subset of the hedge fund industry and the survey provides a breakdown of the $216 billion assets under managements, by the type of trading strategies adopted by the hedge funds. The volume of assets under management that were classified as Managed Futures strategies was $20.3 billion as at July 2004, an increase from the $12.7 billion invested as at July 2003 and the $16.2 billion invested as at the beginning of January 2004. The Eurohedge research also shows that, out of the $216 billion assets under management by the hedge fund community, more than 50% of the managers are domiciled or based in London. London, therefore, remains, by far the dominant centre for European hedge fund activity, accounting for more than 75% of the European total assets under management. The huge growth of the Managed Futures industry in Europe over the past years has possibly benefited from the more established, Managed Futures industry in the United States. 12 This is well documented in the literatures. See for example, Lamm RM (2005). In our paper, all managed futures exhibit positive, but not significant, skewness for the full period, but there is significant positive skewness in some managed futures returns in the in-sample and out of sample. See Table 2. 13 See footnote 6 14 The countries selected are the same as those in Eun & Resnick (1988). It is in the currencies of these countries that the UK investors can hedge currency risk via a well-developed forward market.

10

using a one-month forward currency rate15. We also include six managed futures indexes - also known as the Commodity Trading Advisers (CTAs) indices - in the UK investor portfolios. These are the Currency CTA, discretionary CTA, diversified CTA, finance CTA, equity CTA and Systematic CTA indexes. The source of the data is from CISDM (The Center for International Securities and Derivatives Markets, see cisdm.som.umass.edu). Table 1 describes the strategies used by CTAs. All Managed Futures and MSCI Stock Indexes data are used in the allocation process.

Table 2A, 2B and 2C show the summary statistics for the full period, and the in sample and the out of sample periods. The value of LPM, which measures the average monthly below target variations, is computed assuming the target rate to be zero percent16. Table 2A shows the LPM values are quite similar for the CTA indexes, ranging from about 0.23% to 0.26%. For the stock indexes, it ranges from 0.08% to 0.3%. The table also shows that most of the stock indices are negatively skewed, while most CTA indexes are positive skewed. Table 2B shows that most CTA indexes have relatively lower LPM, from 0.06% to 0.11%. Among them, the diversified CTA, Finance CTA and the Systematic CTA indexes are significantly and positively skewed. However the stock indexes have higher LPM values , ranging from about 0.18% to 0.43%.

[Insert Table 1]

[Insert Table 2]
15

It is more realistic to report findings in UK returns rather than in foreign currency returns since this is from the UK investors perspectives. This is particularly so for the UK institutional investors, who know more about the UK currency forward contracts. Using the currency forward contracts has the advantage of potentially reducing the variability of assets returns, which is in the investors favour. See Eun & Resnick (1988) for more discussions. 16 See footnote 6

11

3.2

Methodology

The minimum variance portfolio analysis is considered as an appropriate benchmark because of its general use in portfolio theory applications. Therefore, the Minimum Variance model alongside the minimum portfolio LPM models are used in the investigation and their findings compared. The following presents the minimum variance portfolio formulations

n ij

Minmize
i 1 j 1

xi x j

(7)

Subject to:
n

rj x j
n

xj 0 xj

1 1, j 1,2,....,n

Where security j,
ij

is the portfolio expected rate of returns, r j is the expected return of

is the expected covariance between returns of index i and of index j, x j

is the proportion invested in asset j.

We use the n-degree portfolio LPM algorithm to model the portfolio downside risk presented in Nawrocki (1991) and Moreno et al (2005). The following presents the minimum n-degree portfolio LPM formulations

LPM
i 1 j 1

xi x j CLPM ij

(8)

12

Where,
CLPM ij LPM i

when i = j

CLPM ij

CLPM

ji

when i

The investor is assumed to be risk averse below the target (returns) variation and the objective function, which includes the above mentioned n-degree portfolio LPM, is as follows:
n n

Minimize
i 1 j 1

xi x j CLPM ij

(9)

Subject to:
n

rj x j
n

xj 0 xj

1 1, j 1,2,....,n

Where

is the expected rate of return for the portfolio, r j is the expected


ij

return of security j,17

is the expected covariance between returns of index i and of

index j, x j is the proportion invested in asset j.

The minimisation function considers the co lower partial moment (CLPM)18. This implies that the lower partial moment for the portfolio is minimised taking into account the relationship of the lower partial moments of the underlying portfolio asset

17

The expected portfolio returns, , is based on the expected returns of the individual assets and their respective weightings. The expected returns of the individual asset are calculated based on the in-sample mean returns, from 1999 to 2002. 18 The CLPM takes a symmetrical form as defined in equation (6). See footnote 9.

13

returns. The models allocation is therefore based on assets with the lowest interacted lower partial moment values in the portfolios.

We assume short selling is prohibited throughout the analysis. The analysis involved optimising the objective functions (8) and (9). For objective function (9), the degree of n, ranging from 1 to 419, are used in the minimisation of the portfolio LPM, with n = 1 exhibiting the most tolerance for below target variation and n = 4 as the least tolerant in that regard. The weights for the portfolios are derived using the constraints for the respective objective functions. The data inputs are returns in UK for all Managed Futures and stock market indexes. This study analyses the performance consequences arising from including these market indexes assets in UK investment portfolios from 1999 to 2006. The estimation interval is 4 years, from 1999 to 2002. The out of sample testing periods are from 2003 to 2006. The holding period is 4 years and the holding period returns are used to compare portfolio returns generated from objective functions (8) and (9).

Discussion of Results

Table 3, which is divided into sections 3A and 3B, shows the main findings. Table 3A shows the asset allocations for the Minimum Variance and the n-degree LPM models (of n=1 to n=4, denoted as LPM1, LPM2, LPM3 and LPM4), and the underlying individual asset skewness for the out-sample periods. Table 3B shows the portfolio statistics for the out of sample observations, showing the average monthly returns, 4 years holding period returns (thereafter, as HPR) and the skewness for the
19

We only use degree of n Nawrocki (1992)

1 as explained in section 2.2, but restricted value of n from 1 to 4, follows that of

14

Minimum Variance and the n-degrees LPM models. Table 4 shows the covariance and the CLPM of the main assets20 allocated in the minimum variance and the various LPM models out of sample.

Table 3A shows the minimum variance model has the highest number of assets allocated. This has the best diversification effects of all the allocation models. The outcome of the allocations (i.e., the out of sample results) shows the minimum variance model produces the smallest standard deviation when compared to the other LPM models. However, it has also the lowest monthly out of sample return of 0.75%. Table 4 shows some values of covariance to be negative, such as those of UK/France stocks and the UK/Germany stocks. These resulted in lower standard deviation, but also lower returns for the portfolio. The allocation of assets in the minimum variance model is based on the assets variance and covariance of the entire return distribution. The asset allocation outcome could become sub-optimal especially when three of the allocated assets are of significant positive skewness in the sample, as was shown to be the case in table 2.

[Insert table 3]

[Insert table 4]

The LPM models, unlike the minimum variance model, have a minimization function for the portfolio LPM. The models specification accommodates return distributions of varying characteristics. The returns series of the underlying assets are

20

Due to lack of spaces, we only discuss and report CLPM or covariance among the 4 or 5 assets, that are weighted the highest of all assets allocated and in total represent more than 50% in the portfolio. See table 3 for full lists of assets allocated in the respective portfolios.

15

transformed21 to capture the below-target variations of the assets, despite their distributional characteristics, for the purpose of minimising the downside risk of the portfolio. The presence of skewness underlying the return distributions should not affect the allocations process as much as in the Minimum Variance portfolio model.

The n-degrees LPM models in table 3 show different degrees of downside risk tolerance, with n = 1 as the most tolerant or more precisely, indifference towards below target variations and n = 4 as the least tolerant in this regard. Table 3 also shows that the asset allocated falls as the value of n increases, implying a reduction in downside risk tolerance levels. It is observed that the average monthly returns and the HPR are all reduced following changes to the value of n in the LPM models. However, the reduction in diversification following from the reduced assets allocated, as observed in table 3, does not increase standard deviation as much as expected. Apart from an increase to 5.03% when switching from the Minimum Variance to LPM1 model, all the other n-degree LPM models do not have standard deviations consistent with the level of diversification. This leads to rather high reward-tosemivariance ratios as shown in table 3. The reward-to-semivariance ratio increases from 7.31 (LPM1) to 24.69 (LPM3), and then falls to 9.64 (LPM4), a pattern that appears to be remarkably similar to that reported by Nawarock (1992).

These portfolio returns are also affected by the CLPM underlying the portfolios optimized by the n-degrees LPM models. Equivalent to the use of covariance in the minimum variance model, in the LPM models, CLPM of the various

21

See footnote 6

16

asset pairs are captured instead. This measures the extent of the interactions of the LPM underlying the asset pairs.

Table 4 shows some negative or relatively lower CLPM. For the LPM1 portfolio, table 4 shows the values of the out samples CLPM to be 0.00704% (Canada/France stock), 0.0782% (Canada/Diversified CTA) and 0.0073% (France stock/Diversified CTA). These relatively low CLPM are indicative of good diversifiers in terms of the below-target variations of the portfolio. The out of sample portfolio produced a monthly return of 1.59%. It is notable that as a result of switching from the minimum variance model to the LPM1 model, an increase in skewness occurs (from -0.19 to 0.05).

Similar patterns of CLPM are present in the LPM2 portfolio. An example is the values of CLPM associated with the Swiss stock, which as shown in table 4, which are mostly negative except for the Swiss/Germany asset pairs. These minimised the below target variation of the LPM2 portfolios. However, as n increases and lesser risk tolerance is incorporated in the LPM model, fewer assets are allocated, which adversely affects diversification - especially in relation to the LPM4 portfolio.

The numbers of assets allocated to the LPM4 portfolio are further reduced. Analysing the CLPM values in table 4 indicates that the German stock is lowly correlated with most assets (between -0.006% and 0.018%) in the LPM4 portfolio. However, the CLPM of the Diversified CTA does not indicate weak (but good) correlations, with the Japanese stock (0.049%) and the Swiss Stock (0.166%) on the below target variation in LPM4 portfolio out sample. These CLPM values are 5 to 15

17

times higher than the CLPM values the German stock is associated with, which seriously reduces the positive downside risk diversification effects and causes a huge increase in the LPM4 portfolios standard deviation to 7.5%, though their weightings may still be smaller compared to the German Stock. The German stock constitutes 80% of the LPM4 portfolio and is significantly skewed out-sample, which subsequently contributes to increasing LPM4 portfolios skewness (significant) to 0.4.

5.

Concluding Remarks

The concept and applications of asymmetric risk estimation have gained in popularity following the use of VaR methodologies in risk management. The discussion and comparison of VaR in relation to lower partial moment (LPM) based on recent research, such as Danielsson et al (2006) and Hyung & de Vries (2005), indicated the much greater applicability of LPM to portfolio allocation problems when investors exhibit a wide range of risk-averse behaviours in relation to below target returns. Indeed, using the n-degree LPM models, it was shown analytically that Value-at-risk is simply a special case of LPM when n=0. It turns out that VaR involves much greater restrictions compared to the n-degree LPM models in explaining risk tolerance levels. The empirical analysis of the paper focused on the ndegree LPM models to analyse the effect of downside risk reduction on UK portfolio diversification and returns and the effect of setting a target threshold return and allowing for the adjustment of risk tolerance level in the n-degree LPM models.

18

The Minimum Variance (MV) model was used alongside the n-degree LPM models in the portfolio asset allocation process, involving both the Stock Market and the Managed Futures Indexes, due to its general application in portfolio theory. The algorithm of the n-degree LPM models allocated assets based on their (transformed) returns to capture the downside risk, despite their distributional characteristics. Therefore, unlike the Minimum Variance portfolio, skewness did not cause any significant problems for the LPM models. However, it was observed that the effect of varying the tolerance of downside risk in the n-degree LPM models was a reduction in the portfolio returns. This increased the skewness preference of investors which also resulted in a large reduction in the number of assets allocated.

The LPM model increased the returns to investors due largely to the relatively lower diversification underlying the allocation process as compared to the Minimum Variance model. This allocation process places the portfolios towards the higher end of the risk-return area of the efficient frontier. Moreover, as the n-degree LPM increased as a consequence of a lower tolerance for downside risk, the portfolio returns were further reduced, implying a significant premium associated with the reluctance to tolerate additional downside risk. Portfolio skewness was increased as a result, indicating the existence of a trade-off between portfolio returns and skewness, a result that was also found by Simkowitz & Beedles (1978) and more recently, by Huang & Yau (2006).

19

To conclude, this paper used the n-degree LPM models to analyse the portfolio diversification outcomes for investors with some tolerance of downside risk. This paper used data on Managed Futures funds that are already diversified. Even so, the ndegree LPM models were still of significant importance, especially as it is increasingly popular for investors to include hedge funds and fund-of-funds type investments within equity portfolios. The findings have implications for the use of managed futures funds within UK equity portfolios, and how the potential benefits of fund diversification could deteriorate following reductions in downside risk tolerance levels. This reinforces the importance of risk (tolerance) perception, particularly downside risk, when making decisions to include managed futures funds in UK equity portfolios, which our findings reveal, could also adversely affect portfolio returns.

20

References

Acerbi, C., Tasche, D., 2002, On the coherence of expected shortfall, Journal of Banking and Finance, 26, p1487-1503

Artzner, P., Delbaen, F., Eber, J. M., Heath, D., 1999, Coherent measures of risk Mathematical Finance 9, 203228

Bawa, V.S., 1975, Optimal Rules for Ordering Uncertain Prospects, Journal of Financial Economics, 2(1), 95-121

Cerrahogiu and Pancholi (2003), The benefits of managed futures, Centre for international securities and derivatives market, University of Massachusetts.

Chunhachinda, P., Dandapani, K., Hamid, S., Prakash, A.J., 1997, Portfolio selection and skewness: Evidence from international stock markets, Journal of Banking and Finance, 21(2), 143-168.

Danielsson, J., Jorgesen, B. N., Sarma, M., De Vries, C.G (2006), Comparing downside risk measures for heavy tailed distributions, Economic letters, 92, p202208.

Edwards, R., Caglayan, M.O., 2001, Hedge Fund and Commodity Fund Investments in Bull and Bear Markets, Journal of Portfolio Management, Summer, 97-108

21

Elton, E. J., Gruber, M.J., Urich, T. (1978), Are betas best? Journal of Finance, 33, p1375-1384

Epstein, C.B., (edited), 1992, Managed futures in the institutional portfolio, John Wiley & Sons, first edition, New York.

Eun, C., Resnick, B., 1988, Exchange Rate Uncertainty, Forward Contracts, and International Portfolio Selection, Journal of Finance, 4, 197 to 215.

Fishburn, P.C., 1977, Mean-Risk Analysis with Risk Associated with Below-Target Returns, American Economic Review, 67(2), 116-126.

Guthoff, A, Pfingsten, A., Wolf, J (1997), On the compatibility of Value-at-risk, other risk concepts and expected utility maximization, in: Hipp, C. et.al. (eds)

Harlow, W.V., 1991, Asset Allocation in a downside risk framework, Financial Analyst Journal, September/October, 28-40.

Huang C.J., Yau R, 2006, The investor preferences and portfolio selection: is diversification an appropriate strategy? Quantitative Finance, 6(3), p255-271

Hyung, N, De Vries, C.G (2005), Portfolio Diversification effects of Downside risk, Journal of Financial Econometrics, 3(1), p107-125.

22

Jorion P. (2001), Value-at-Risk: the new Benchmark for Managing Financial Risk. McGraw-Hill: New York

Kaplanski, G, Kroll, Y (2001), VaR Risk Measures versus Traditional Risk Measures: An Analysis and Survey, Journal of Risk, 4(3).

Lai, T.Y., 1991, Portfolio selection with skewness: A multiple-objective approach, Review of Quantitative Finance and Accounting, 1, 293-305.

Lamm, R.M., 2003, Asymmetric Returns and Optimal Hedge fund Portfolios, Journal of Alternative Investments, Fall, 9-21.

Lamm, R. M, 2005, The Answer to Your Dreams? Investment Implications of Positive Asymmetry in CTA Returns, The Journal of Alternative Investments, spring pp. 22-32.

Markowitz, H.,"Portfolio Selection," Journal of Finance, 1952, v7(1), 77-91.

Markowitz, H., 1959, Portfolio Selection, First Edition, New York: John Wiley & Sons.

Moreno, D., Marco, P., Olmeda, I (2005), Risk Forecasting models and optimal portfolio selection, Applied Economics, 37, p1267-1281

Nawrocki, D., 1991, Optimal Algorithms and Lower Partial Moment: Ex Post Results, Applied Economics, 23(3), 465-470.

23

Nawrocki, D., 1992, The Characteristics of Portfolios Selected by N-Degree Lower Partial Moment, International Review of Financial Analysis, 1(3), 195-209.

Nawrocki, D., 1999, A brief history of downside risk measures, Journal of Investing, 8, 9-25.

Prakash, A. J., Chang, C.H., Pactwa, T.E., 2003, Selecting a portfolio with skewness: Recent evidence from US, European, and Latin American equity markets, Journal of Banking and Finance, 27(7), 1375-1390.

Roy, A. D. "Safety First And The Holding Of Assets," Econometrica, 1952, v20(3), 431-449.

Scott, R., & Horvath, P., 1980, In the direction of preference for higher order moments, Journal of Finance, 35, 915-919.

Simkowitz, M.A., Beedles, W.L., 1978, Diversification in a Three Moment World, Journal of Financial and Quantitative Analysis, 13, 927-941.

Veld, Chris and Veld-Merkoulova, Yulia 2008, 'The risk perceptions of individual investors', Journal of Economic Psychology, Vol 29, pp 226-252

24

Appendix 1: Derivation of Value-at-risk from Lower Partial Moment of zero (developed partially from Guthoff et al (1997))

Defining n-degree LPM as:

LPM n (t )

(t - x)n df(x)

where t is the target rate of return, f(x)is the probability of getting a return less than t, x is the security returns and n is the power or exponential variable that determines the weights investors place on deviations.

If n = 0, n-degree LPM derived as follows:

LPM 0 (t )

(t - x)0 df(x) 1 f(x)d(x)

(1)

= F(t)

Therefore, when n = 0, i.e., when no weight is placed on the derivation from the target return, t, LPM is a cumulative distribution function of normality (F(t)).

Setting the target as zero and then minus the value at risk, (i.e., the pre-determined worst expected loss of the security), we get the following Since then

LPM 0 (t )

F (t ) ,

from (1)

LPM 0 ( VaR( p))

F ( VaR( p))

Equivalent to: VaR( p)

F 1 ( LPM ( VaR( p)))

Proof: Value at risk is transformed into Lower Partial Moment of zero, LPM 0 ( =

VaR( p)) , of target t

VaR( p) , giving the probability that the actual loss to be greater than

VaR( p)

25

Table 1

Table 1: Commodity Trading Advisor (CTAs) investment styles and descriptions

Commodity Trading Advisors

Commodity Trading Advisors are specialised traders in the futures and option markets, whose instrumented traded are often treated as an asset class. These traded derivatives are normally managed as a fund, and consisting of investments in the financial futures market, commodity futures market and some over-the-counter (OTC) derivatives contacts, such as the forward and options contracts. The following descriptions of the various CTAs are those that are used in this study. The data used in this study are the monthly Net Asset Values (NAV) of the assets under management of the respective CTAs, classified by the investment style, and weighted according to the value of each CTAs assets under management.

Investment Style Currency CTAs1 Financial CTAs1 Diversified CTAs1 Discretionary CTAs2

Brief Descriptions and the main Derivatives instruments invested Trade mainly on futures, forwards and options on currencies Trade futures, forwards, and options on fixed-income instruments Trade futures, forwards, and options on all types of commodities and financial instruments Trade on most derivative instruments, except the key in this case is that the advisor may or may not follow the signals being generated by the trading system, unlike most other CTAs. Discretionary CTA, apart from using computer software programs to follow price trends and perform quantitative analysis, also forecast prices by analysis of supply and demand factors and other market information Trade mainly on a wide variety of OTC and exchange traded equity index futures and options. Trade a wide variety of OTC and exchange traded forward, futures and options markets, except that they often adopt a predetermined systematic trading model and involved, for example, momentum or contrarian strategy in their models.

Equity CTAs3 Systematic CTAs3

1 2

Source: Edwards & Caglayan, (2001) Source: Epstein, C.B. (1992), pg 125. 3 Source: The CISDM Website

Table 2

Table 2: Descriptive statistics summary for the Returns of the MSCI and CTA Indexes A) Descriptive Statistics for the returns of the MSCI stock and CTA indexes for the full period - 1999 to 2006 MSCI Stock/Managed Futures Indexes MSCI Canada index MSCI Japan Index MSCI Switzerland Index MSCI US Index MSCI UK Index MSCI France Index MSCI Germany Index Currency CTA Diversified CTA Equity CTA Finance CTA Discretionary CTA Systematic CTA Mean 3.09% 1.68% 1.22% -0.61% 0.17% 0.76% 0.62% -0.46% -0.21% -0.25% -0.04% 0.04% -0.32% Max 25.74% 32.64% 19.37% 15.53% 8.47% 13.94% 19.77% 17.00% 22.22% 16.04% 23.17% 19.45% 22.45% Min -11.08% -17.67% -17.50% -16.56% -12.77% -15.20% -24.23% -14.52% -14.84% -13.15% -14.87% -13.21% -13.70% Std. Dev. 8.95% 10.64% 5.86% 7.45% 3.73% 5.64% 7.17% 6.70% 7.31% 7.28% 7.12% 7.28% 6.97% Skew 0.3076 ***0.8386 -0.0769 0.0190 ***-0.9339 -0.3734 **-0.3990 0.1076 0.3062 0.2026 0.3682 0.3362 0.3329 LPM 0.18% 0.30% 0.12% 0.31% 0.08% 0.15% 0.25% 0.24% 0.26% 0.26% 0.23% 0.23% 0.24% Kurtosis 2.4493 3.6500 3.5779 2.5919 4.4165 3.1048 4.2095 2.5497 3.0528 2.2078 3.3802 2.6954 3.2413 Jarque-Bera (JB) 2.7268 12.9409 1.4304 0.6721 21.9827 2.2749 8.3987 0.9961 1.5110 3.1673 2.7467 2.1795 2.0062

Note: 1) The Jarque-Bera (JB) Statistics tests for skewness by taking into account kurtosis. It is estimated as JB = N[s2/6 + (k-3)2/24], where S denotes the value of, skewness and k denotes the value of kurtosis, N denotes the number of data used for the test. The JB test follows a chi square distribution with 2 degree of freedom. 2) (***) indicates 1% level significance (critical value for chi square is 9.21) and (**) indicates 5% level significance (critical value for chi square is 5.991). 3) The return of the index values are all in UK, converted from foreign currency using the one month currency forward contract. 4) LPM measures the below target variance. It is based on the 1 k Formula LPM (n, t) [ Max(0, (t R )] n Where K is the number of observations, t is the target return, n is the degree of the lower partial moment, RT is the return for
k
T i 1

the asset during time period T, and Max is a maximisation function which chooses the larger of two numbers, 0 or (t - RT).

Table 2 (con't) : Descriptive statistics summary for the Returns of the MSCI and CTA Indexes B) Descriptive Statistics for the returns of the MSCI stock and CTA indexes for the in-Sample period - 1999 to 2002 MSCI Stock/Managed Futures Indexes MSCI Canada index MSCI Japan Index MSCI Switzerland Index MSCI US Index MSCI UK Index MSCI France Index MSCI Germany Index Currency CTA Diversified CTA Equity CTA Finance CTA Discretionary CTA Systematic CTA Mean 1.52% 4.20% 0.40% 1.59% -0.81% 0.09% -0.54% 2.48% 2.97% 2.63% 2.81% 3.03% 2.64% Max 20.88% 32.64% 10.57% 15.53% 7.92% 13.94% 19.77% 17.00% 22.22% 14.95% 23.17% 16.62% 22.45% Min -10.70% -17.67% -17.50% -16.56% -12.77% -15.20% -24.23% -8.39% -12.11% -13.15% -11.77% -9.88% -11.16% Std. Dev. 8.18% 13.79% 6.07% 7.26% 4.54% 6.90% 8.60% 5.61% 6.06% 6.21% 6.06% 5.59% 5.86% Skew 0.4465 0.3063 -0.4815 -0.3158 -0.5628 -0.1760 -0.3213 0.1726 **0.5472 -0.3428 ***0.6374 0.0739 ***0.6735 LPM 0.20% 0.43% 0.18% 0.20% 0.15% 0.24% 0.43% 0.07% 0.06% 0.11% 0.07% 0.06% 0.06% Kurtosis 2.4984 2.1420 2.9377 2.9063 2.9522 2.2989 3.1226 2.9459 4.4674 2.8284 5.1438 2.9347 4.9489 Jarque-Bera (JB) 2.0977 2.2227 1.8624 0.8152 2.5389 1.2309 0.8558 0.2442 6.7021 0.9987 12.4428 0.0522 11.2251

Note: 1) The Jarque-Bera (JB) Statistics tests for skewness by taking into account kurtosis. It is estimated as JB = N[s2/6 + (k-3)2/24], where S denotes the value of, skewness and k denotes the value of kurtosis, N denotes the number of data used for the test. The JB test follows a chi square distribution with 2 degree of freedom. 2) (***) indicates 1% level significance (critical value for chi square is 9.21) and (**) indicates 5% level significance (critical value for chi square is 5.991). 3) The return of the index values are all in UK, converted from foreign currency using the one month currency forward contract. 4) LPM measures the below target variance. It is based on the 1 k Formula LPM (n, t) [ Max(0, (t R )] n Where K is the number of observations, t is the target return, n is the degree of the lower partial moment, RT is the return for
k
T i 1

the asset during time period T, and Max is a maximisation function which chooses the larger of two numbers, 0 or (t - RT).

Table 2 (con't) : Descriptive statistics summary for the Returns of the MSCI and CTA Indexes C) Descriptive Statistics for the returns of the MSCI stock and CTA indexes for the out-sample period - 2003 to 2006 MSCI Stock/Managed Futures Indexes MSCI Canada index MSCI Japan Index MSCI Switzerland Index MSCI US Index MSCI UK Index MSCI France Index MSCI Germany Index Currency CTA Diversified CTA Equity CTA Finance CTA Discretionary CTA Systematic CTA Mean 4.67% -0.83% 2.04% -2.81% 1.15% 1.42% 1.78% -3.40% -3.38% -3.13% -2.90% -2.94% -3.27% Max 25.74% 9.85% 19.37% 14.81% 8.47% 11.55% 18.41% 11.82% 13.94% 16.04% 14.74% 19.45% 12.57% Min -11.08% -11.59% -10.25% -15.84% -5.25% -9.52% -11.49% -14.52% -14.84% -12.68% -14.87% -13.21% -13.70% Std. Dev. 9.48% 5.10% 5.59% 7.05% 2.35% 3.98% 5.23% 6.45% 7.11% 7.17% 7.01% 7.60% 6.78% Skew 0.1101 0.0125 0.5141 0.3334 -0.0608 -0.2266 **0.4785 0.4664 0.7063 **0.9567 0.6833 ***1.1173 0.6349 LPM 0.17% 0.16% 0.07% 0.42% 0.01% 0.05% 0.07% 0.42% 0.45% 0.41% 0.40% 0.41% 0.42% Kurtosis 2.4087 2.5091 3.7984 2.9540 4.1773 3.6870 4.8079 2.7009 3.0629 3.3123 3.0934 4.0014 2.8715 Jarque-Bera (JB) 0.7963 0.4833 3.3895 0.8937 2.8018 1.3548 8.3688 1.9194 3.9987 7.5167 3.7529 11.9920 3.2582

Note: 1) The Jarque-Bera (JB) Statistics tests for skewness by taking into account kurtosis. It is estimated as JB = N[s2/6 + (k-3)2/24], where S denotes the value of, skewness and k denotes the value of kurtosis, N denotes the number of data used for the test. The JB test follows a chi square distribution with 2 degree of freedom. 2) (***) indicates 1% level significance (critical value for chi square is 9.21) and (**) indicates 5% level significance (critical value for chi square is 5.991). 3) The return of the index values are all in UK, converted from foreign currency using the one month currency forward contract. 4) LPM measures the below target variance. It is based on the 1 k Formula LPM (n, t) [ Max(0, (t R )] n Where K is the number of observations, t is the target return, n is the degree of the lower partial moment, RT is the return for
k
T i 1

the asset during time period T, and Max is a maximisation function which chooses the larger of two numbers, 0 or (t - RT).

Table 3

Table 3 : Portfolio Allocations and the Out-Sample Portfolio Results of Minimum Variance and Minimum LPM (estimating using 48 monthly returns from 1999 to 2002) for the MSCI stock market and CTA indexes A) Portfolio Assets Allocations

Assets out Portfolio Assets Sample Skewness MV

LPM (n=1)

LPM (n=2)

LPM (n=3)

LPM (n=4)

MSCI Canada index MSCI Japan Index MSCI Switzerland Index MSCI US Index MSCI UK Index MSCI France Index MSCI Germany Index Currency CTA Diversified CTA Equity CTA Finance CTA Discretionary CTA Systematic CTA Total allocation No. of assets allocated B) Out-Sample Results Average monthly returns 4 years (2003 to 2006) holding periods returns Standard Deviation Skewness

0.1101 0.0125 0.5141 0.3334 -0.0608 -0.2266 **0.4785 0.4664 0.7063 **0.9567 0.6833 ***1.1173 0.6349

9% 0% 25% 6% 13% 16% 12% 3% 3% 4% 4% 1% 4% 100% 12

40% 2% 8% 0% 4% 20% 1% 0% 13% 2% 4% 1% 3% 100% 11

8% 0% 19% 5% 32% 18% 16% 1% 0% 0% 1% 0% 0% 100% 8

7% 5% 19% 0% 31% 17% 15% 0% 0% 0% 5% 0% 0% 100% 7

0% 7% 2% 0% 6% 0% 80% 0% 5% 0% 0% 0% 0% 100% 5

MV 0.75% 38.35%

LPM 1 *1.59% 97.76%

LPM 2 ***1.44% 94.72%

LPM 3 ***1.37% 88.86%

LPM 4 **1.31% 78.59%

4.20% -0.19 0.07% 5.44

5.03% 0.05 0.17% 7.31

4.84% 0.12 0.05% 23.78

4.70% 0.19 0.04% 24.69

7.50% *0.40 0.10% 9.64

Semi-variance (SV)
Reward to Semi-variance (R/SV) ratio
Note:

1) The critical values for testing the differences of the portfolio returns among the various allocation methods (i.e., LPM of n=1, n=2, n=3, n=4 and the MV) are 2.43 (5% significant level), 3.45 (1% significant level). As the F critical value (p value) is about 1.428 (0.000) ,the null hypothesis of no difference among the monthly returns series generated by the various allocation methods can therefore be rejected. These portfolios returns are therefore significantly different from one another. Our results are similar to that in Nawrocki (1992), which show that portfolio out sample returns do also decrease, from 2.514 to 2.4849, as the LPM is adjusted from n=1 to n=4. 2) (***) indicates 1% level significance (critical value for chi square is 9.21), (**) indicates 5% level significance (critical value for chi square is 5.991) and (*) indicates 10% level significance (critical value for chi square). The estimation of skewness is based on the Jarque-Bera statistics test . 3) We defined Reward-to-semi-variance ratio, R/SV, as: , with being the average monthly portfolio returns, for i = 1 to 5, for minimum variance, LPM1 to LPM4 portfolio, and as the risk free rate, which we used the UK 3 month treasury bills.

Table 4

Table 4: Analysis of Covariance and CLPM underlying the assets in the models Minimum Variance Assets allocated (weighting) Switzerland stock (25%), UK stock (13%), France stock (16%), Germany stock (12%) Assets' pairs Swiss/UK Stock Swiss/France stock Swiss/Germany stock UK/France Stock UK/Germany Stock France/Germany Stock Out sample covariance 0.0165 0.0978 0.1555 -0.0175 -0.0115 0.1948

LPM1 Assets allocated (weighting) Canada stock (40%); France stock (20%); Diversified CTA (13%); Switzerland stock (8%) Assets' pairs Canada/France stock Canada/Diversified CTA France stock/Diversified CTA Swiss/Canada stock Swiss/Diversified CTA Swiss/France stock Out sample CLPM 0.0070 0.0782 0.0073 0.0092 0.0073 0.0048

LPM2 Assets allocated (weighting) Switzerland stock (19%), UK stock (32%); France stock (18%), Germany (16%) Assets' pairs Swiss/UK Stock Swiss/France Stock Swiss/Germany stock UK/France Stock UK/Germany stock France/Germany Stock Out sample CLPM -0.0016 -0.0017 0.0024 -0.0015 -0.0018 0.0576

Note: 1) We only discuss CLPM or covariance among the 4 or 5 assets, that are weighted the highest of all assets allocated and in total represent more than 50% of the portfolio. See table 3 for the full lists of assets allocated in the respective portfolios. 2) CLPM is calculated as CLPM ( SDni )( SDnj )( rij ) where r is the correlation coefficient between securities i and j, SDni and SDnj are the semi deviations for security i and j for m the period n. The semi deviation is calculated as SDni { 1 [ Max(0, h Rit )] n }1 / nwhere h is the target return, m is the number of observation and n is the LPM degree m t 1

Table 4 (con't) : Analysis of Covariance and CLPM underlying the assets in the models LPM3 Assets allocated (weighting) Switzerland stock (19%), UK stock (31%), France stock (17%), Germany stock (15%) Assets' pairs Swiss/UK Stock Swiss/France Stock Swiss/Germany stock UK/France Stock UK/Germany stock France/Germany Stock Out sample CLPM -0.0029 -0.0055 -0.0025 -0.0025 -0.0027 0.1203

LPM4 Assets allocated (weighting) Japan Stock (7%), Switzerland stock (2%), UK stock (6%), Germany stock (80%), Diversified CTA (5%) Assets' pairs Japan/Swiss Stock Japan/UK Stock Japan/Germany Stock Japan/Diversified CTA Swiss/UK Stock Swiss/Germany Stock Swiss/Diversified UK/Germany stock UK/Diversified CTA Germany/Diversified CTA Out sample CLPM 0.0066 -0.0067 0.0077 0.0494 -0.0035 -0.0062 0.1659 -0.0034 -0.0139 0.0183

Note: 1) We only discuss CLPM or covariance among the 4 or 5 assets, that are weighted the highest of all assets allocated and in total represent more than 50% of the portfolio. See table 3 for the full lists of assets allocated in the respective portfolios. 2) CLPM is calculated as CLPM ( SDni )( SDnj )( rij ) where r is the correlation coefficient between securities i and j, SDni and SDnj are the semi deviations for security i and j for m the period n. The semi deviation is calculated as SDni { 1 [ Max(0, h Rit )] n }1 / nwhere h is the target return, m is the number of observation and n is the LPM degree m t 1

You might also like