ADVANCESINPORTFOLIO
CONSTRUCTIONAND
IMPLEMENTATION

Editedby
StephenSatchell
AlanScowcroft 2003

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Contents
ListofContributors xi
Introduction xvii
1Areviewofportfolioplanning:modelsandsystems1
GautamMitra
1.1IntroductionandOverview2
1.2AlternativeComputationalModels4
1.3SymmetricandAsymmetricMeasuresofRisk14
1.4ComputationalModelsinPractice18
1.5PreparationofData:FinancialDataMarts22
1.6SolutionMethods25
1.7ComputationalExperience27
1.8DiscussionsandConclusions32
1.9Appendix1:PiecewiseLinearApproximationofthe
QuadraticForm32
1.10Appendix2:ComparativeComputationalViews
oftheAlternativeModels34
References37
WebReferences39
Acknowledgements39
2Generalizedmean-varianceanalysisandrobustportfolio
diversi?cation40
StephenMWrightandSESatchell
2.1Introduction41
2.2GeneralizedMean-VarianceAnalysis44

vi Contents
2.3TheStatePreferenceTheoryApproachtoPortfolio
Construction46
2.4ImplementationandSimulation48
2.5ConclusionsandSuggestedFurtherWork53
References54
3Portfolioconstructionfrommandatetostockweight:
apractitioner°Osperspective5
DrJulianCoutts
3.1Introduction56
3.2AllocatingTrackingErrorforMultiplePortfolioFunds58
3.3TrackingErrorsforArbitraryPortfolios64
3.4ActiveCAPM,orHowFarShouldaBetbeTaken?82
3.5ImplementingIdeasinRealStockPortfolios89
3.6Conclusions92
References94
4Enhancedindexation95
AlanScowcroftandJamesSefton
4.1Introduction96
4.2ConstructingaConsistentView97
4.3EnhancedIndexing103
4.4AnIllustrativeExample:Top-downorBottom-up?106
4.5Conclusions119
4.6Appendix1:DerivationoftheTheil(R)CGoldberge
MixedEstimator120
4.7Appendix2:Optimization121
References123
Notes124
5Portfoliomanagementundertaxes125
DandiBartolomeo
5.1Introduction125
5.2DoTaxesReallyMattertoInvestorsandManagers?126
5.3TheCoreProblems127
5.4TheStateoftheArt128
5.5TheMulti-PeriodAspect130
5.6LossHarvesting132
5.7After-TaxBenchmarks132

Contents vii
5.8Conclusions133
References133
6Usinggeneticalgorithmstoconstructportfolios135
DrTWilding
6.1LimitationsofTraditionalMean-VariancePortfolio
Optimization135
6.2SelectingaMethodtoLimittheNumberofSecurities
intheFinalPortfolio141
6.3PracticalConstructionofaGeneticAlgorithm-Based
Optimizer145
6.4PerformanceofGeneticAlgorithm150
6.5Conclusions158
References159
7Near-uniformlydistributed,stochasticallygeneratedportfolios161
RichardDawsonandRichardYoung
N-DimensionalExperimental
7.1Introduction(R)CATractabl
Control162
7.2Applications163
7.3DynamicConstraints165
7.4ResultsfromtheDynamicConstraintsAlgorithm173
7.5ProblemsandLimitationswithDynamicConstraints
Algorithm174
7.6ImprovementstotheDistribution175
7.7ResultsoftheDynamicConstraintswithLocal
DensityControl180
7.8Conclusions185
7.9FurtherWork185
7.10Appendix1:ReviewofHoldingDistributioninLow
DimensionswithMinimalConstraints186
7.11Appendix2:ProbabilityDistributionofHolding
WeightinMonteCarloPortfoliosinNDimensions
withMinimalConstraints189
7.12Appendix3:TheEffectsofSimpleHoldingConstraints
onExpectedDistributionofAssetHoldingWeights190
7.13Appendix4:PropertiesofHyper-Solids191
References192
Notes192

viii Contents
8Modellingdirectionalhedgefunds(R)Cmean,variancean
correlationwithtrackerfunds193
EmmanuelAcar
8.1Introduction193
8.2MeanandVarianceofDirectionalStrategies194
8.3CorrelationwithTrackerFund196
8.4ParametersEstimation198
8.5OptimalAllocation199
8.6AnEmpiricalApplicationtotheCurrencyMarkets207
8.7Conclusions208
8.8Appendix1:MeanandVarianceofDirectional
Strategies209
8.9Appendix2:CorrelationwithTrackerFund210
8.10Appendix3:OptimalAllocation212
References213
Notes214
Acknowledgements214
9Integratingmarketandcreditriskin?xedincomeportfolios215
AllaGilandYuriPolyakov
9.1Introduction215
9.2HowtoMeasureMarketandCreditRisk216
9.3TheWaysofConstructingLossDistributions218
9.4ComponentsofCreditRisk220
9.5PortfolioApproach227
9.6Conclusions232
9.7Appendix233
References240
Notes242
10Incorporatingskewnessandkurtosisinportfoliooptimization:
amultidimensionalef?cientset243
GustavoMdeAthaydeandRenatoGFl?ores,Jr
10.1Introduction243
10.2TheAlgebraofMultivariateMoments246
10.3ThePortfolioFrontier:ExpectedReturn,Skewnessand
Kurtosis248
10.4Conclusion256
References256
Notes257

11Balancinggrowthandshortfallprobabilityincontinuoustime
activeportfoliomanagement258
SidBrowne
11.1Introduction258
11.2SomeBasics259
11.3ActivePortfolioManagement261
11.4TradingoffRiskandReturninActivePortfolio
Management:FractionalObjectives265
11.5Risk-ConstrainedMinimalTime266
References268
12Assessingthemeritsofrank-basedoptimizationfor
portfolioconstruction269
SoosungHwang,StephenESatchellandStephenMWright
12.1Introduction269
12.2OptimalPortfoliowithRanks270
12.3EmpiricalTests273
12.4Conclusions288
References289
Notes289
13Themean-downsideriskportfoliofrontier:anon-parametric
approach290
GustavoMdeAthayde
13.1Introduction290
13.2TheMean-DSRPortfolioFrontier:TheTraditional
Approach293
13.3TheMultivariateCase297
13.4AKernelApproach299
13.5TheKernelApproachtotheMultivariateCase303
13.6TheMean-DSRPortfolioFrontierUsingKernelEstimates305
13.7AssetPricing306
13.8Conclusion308
References308
14Someexactresultsforef?cientportfolioswithgivenreturns310
GHHillierandSESatchell
14.1Introduction310
14.2PropertiesoftheRiskEstimator313
14.3PropertiesoftheEstimatedPortfolioWeights317
14.4TheRisklessAssetCase321

x Contents
14.5Conclusions323 323
14.6Appendix:TheUnconditionalMeanof
References325
Notes325
15Optimalassetallocationforendowments:Alarge
deviationsapproach326
MichaelStutzer
15.1Introduction326
15.2TheAssetAllocationModel327
15.3AnIllustrativeExample329
15.4Conclusions332
References332
Notes332
Acknowledgements332
16Methodsofrelativeportfoliooptimization333
NiklasWagner
16.1Introduction333
16.2SomeBackgroundonRelativePortfolioOptimization334
16.3ModelApproachesforRelativePortfolioOptimization335
16.4DiscussionoftheModels339
16.5Conclusion340
References340
Notes341
17Predictingportfolioreturnsusingthedistributionsofef?cient
setportfolios342
CJAdcock
17.1Introduction342 and V 344
17.2Ef?cientSetMathematicsforGiven
17.3TheEffectofForecasts347
17.4ModelandProcess348
17.5DataandEmpiricalResults349
17.6Conclusions352 352
17.7Appendix:EffectofEstimationErrorin
References354
Notes354
Acknowledgements355
Index357