Download Applying Post-Modern Portfolio Theory to International Performance

Applying Post-Modern
Portfolio Theory to
International Performance
Measurement
Brian M. Rom, President
Investment Technologies
Outline
• Post-Modern Portfolio Theory
• Case Studies
Post-Modern Portfolio Theory
• Downside risk replaces standard
deviation
• Distributions do not have to be
normal or symmetric
Downside Risk
• The standard deviation of returns below the
goal
• Differentiates between risk and uncertainty
• Naturally incorporates skewness
• Recognizes that upside volatility is better
than downside volatility
• Combines frequency and magnitude of bad
outcomes
• No single riskless asset
Elements of PMPT
The Goal
• Questions to Identify the Proper Goal:
•
•
•
What is at stake here?
What are we trying to accomplish?
When does it go from good to bad?
• Examples of Goals:
•
•
•
•
•
Minimum achievable return
Benchmark or index portfolio
Comparative universe median
Maintain pension contribution below specified
amount
Achieve target wealth in order to retire
Elements of PMPT
Sortino Ratio
• [Return-Goal]/Downside Risk
• PMPT analogue of Sharpe Ratio
(Return-Riskfree Rate)/Standard
Deviation
Elements of PMPT
Volatility Skewness
[Percent variance above the mean]/
[Percent variance below the mean]
Elements of PMPT
Downside Frequency
Frequency of failure to achieve the
goal
Elements of PMPT
Average Downside Deviation
Average deviation below the goal
Case Study #1
How Asymmetrical are
International Investment
Returns?
Volatility Skewness
Skewness of International
Equity Indexes: 1988-1997
1.00
0.00
55 Indexes
Sources: Barings, Lipper Analytical, Goldman Sachs,
Independence International Associates, Inc., MSCI
Volatility Skewness
Skewness of International LargeCap Equity Managers: 1993-1997
2.00
1.00
0.00
106 Managers
Source: Effron/PSN
Volatility Skewness
Skewness of International SmallCap Equity Managers: 1993-1997
2.00
1.00
0.00
34 Managers
Source: Effron/PSN
Volatility Skewness
Skewness of International Fixed
Income Managers: 1993-1997
1.00
0.00
26 Managers
Source: Effron/PSN
Case Study #2
Performance analysis of two large-cap
international equity investment
managers for period
1993-1997
Risk and Return
30
27.0
25
20
18.2
17.6
15
12.5
10
6.9
5
3.6
0
Annualized Compound Average (%)
Standard Deviation (%)
Downside Deviation @ 10.00% Goal (%)
Manager A
Manager B
Risk-Adjusted Returns
6
5.59
5
4
3
2
1.73
1.73
1.41
1
0
Sortino Ratio @ 10.00% Goal
Manager A
Sharpe Ratio
Manager B
Skewness Analysis
Manager
Volatility
Skewness
% Upside
Volatility
% Downside
Volatility
A
1.30
56.5%
43.5%
B
0.65
39.5%
61.5%
Manager B
Manager A
-15
-10
-5
0
5
10
15
Return (%)
Manager A
Manager B
20
25
30
THE INVESTMENT WORLD
IS NOT ALWAYS SYMMETRICAL!
Wrap Up
• DR is standard deviation of returns below the
goal
• Differentiates between risk and uncertainty
• Naturally incorporates skewness
• Recognizes that upside volatility is better
than downside volatility
• Skewness of returns can be significant
• DR handles skewness; SD does not
• Concepts are theoretically sound and
experimentally validated