A Comparison of Minimum Risk Portfolios under the Credit Crunch Crisis

doi:10.4236/jmf.2011.12005

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Journal of Mathematical Finance, 2011, 1, 34-39

doi:10.4236/jmf.2011.12005 Published Online August 2011 (http://www.SciRP.org/journal/jmf)

A Comparison of Minimum Risk Portfolios under the

Credit Crunch Crisis

Theodoros Mavralexakis1, Konstantinos Kiriakopoulos2,3, George Kaimakamis4, Alexandros Koulis3

1Proton Bank, Risk Management Department, Athens, Greece

2Proton Bank, Capital Markets, Athens, Greece

3Department of Regional Economic Development, University of Central Greece, Lamia, Greece

4Department of Mathematics and Applied Mechanics, Hellenic Army Academy, Athens, Greece

E-mail: [email protected], [email protected], {gmiamis, koulisal}@gmail.com

Received July 4, 2011; revised July 24, 2011; accepted August 2, 2011

Abstract

In this paper the behaviour of various popular risk portfolios measures used for portfolio construction are

compared using data from the recent financial crisis. Results are revealing the way optimal portfolios should

be constructed. Despite the conventional wisdom, short selling gives only a marginal improvement to portfo-

lio performance during the crisis period. Optimal semivariance portfolio produces better results than the

portfolio constructed with the more advanced expected short fall method. Additional historical information

has added to performance up to a point and long dated history seems not to be commensurate with additional

benefits. Rebalancing frequency seems to have an optimal point that favours neither overtrading nor the

conventional buy and hold strategy.

Keywords: Portfolio Optimization, Expected Shortfall, Minimum Variance

1. Introduction

The financial market turmoil, which emerged in late

2007, has led to the most severe financial crisis since the

Great Depression. The bursting of the housing bubble

forced banks to write off several hundred billion dollars

in bad loans caused by mortgage delinquencies. At the

same time, the stock market capitalization of the major

banks declined by more than twice as much. While the

overall mortgage losses were large on an absolute scale,

they were still relatively modest compared to the $8 tril-

lion of US stock market wealth losses between Oc- tober

2007 when the stock market had reached an all- time

high and October 2008. Stulz [1] mentions the need for

taking into account events of small probability that can

lead to such big losses.

This highlights once again the importance of con-

structing minimum risk portfolios with no implicit nor-

mality assumptions on returns. This work attempts to

search for a methodology to construct optimal minimum

risk portfolios by capitalizing on different risk measures.

Various minimum risk portfolio selection measures, us-

ing data from the recent financial crisis, are compared.

These measures are used ex-ante, and optimal portfolios

are constructed. In this way, the preferences of a risk-

avert investor who wants to choose portfolios ex-ante

based on different minimum risk measures are reflected.

The risk measures optimized are variance (variance

minimization-VM), the Expected Shortfall (ES) and the

semivariance method (SEMI). Results are compared to

the results produced by the naive method (NM) and by

using various benchmark indices. Although the variance

measure ([2]) is criticized for its simplicity since it uses

only the first two moments for portfolio selection and

implicitly assumes normality of portfolio returns, it re-

mains a well-accepted measure at least for comparison

reasons. Modern VAR or ES can be either as a constraint

embedded on broader stochastic portfolio maximization

problem ([3,4]) or as an objective function to be mini-

mized ([3,5-7]).

Extensions when the exit time is uncertain can be

found in [8]. The lack of subadditiv ity of the VAR meas-

ure ([9-11]) makes the ES measure a better candidate for

optimization since it is consistent to risk management

objectives for capital allocation, especially within the

scope of the Basel II regulation framework. VAR/ES

methods has also been extensively used for derivatives

portfolio ([12,13]). Gilli and Schummann [14] investi-

T. MAVRALEXAKIS ET AL.

gate the empirical performance of alternative selection

criteria in portfolio optimization. Although the results

presented there have a great sensitivity to small data

perturbations, alternative selection criteria such as the

semivariance measure seems to produce superior results

to the variance measure. This is the reason semivariance

minimization is included in the portfolio selection crite-

ria. The naive method, although has a questionable effi-

ciency ([15]), is used for reasons of comparison since its

diversification is guaranteed. This paper is organized as

follows: In Section 2 the optimization methodology is

presented. Section 3 includes the data used and the soft-

ware employed. Our main results can be found in Section

4. Conclusions and extensions can be found in Section 5.

2. Optimization Methodology

We employ three minimization programs: the variance

minimization, the expected short fall minimization and

the semivariance minimization. The objective is to find

the optimal portfolios that minimize the programs above

and to actually test them during the recent crisis. We use

the following notation:

N: is the number of portfolio assets.

T, 2

T: are the first and the last day respectively in the

period under examination.

T: is the number of trading days in the periods [1

T].

t: is the first day of portfolio rebalancing.

H: is the number of trading days in the historical win-

dows used for the calculation of portfolio variance,

semivariance or expected shortfall, when needed. It must

hold 1

tT H .

: is the number of days until rebalancing. Rebal-

ancing takes place at dates tjF



, 0,, t

jL, where

L is the integer part of the ratio 2

.



,,, T

jjj J

 

, 0,, t



 represent vector

of the weights in the N assets at the j rebalancing period.

In case of short sale restrictions it holds 01





.

Moreover, 11





. Let χ be the set of all possible

admissible portfolio vectors.

Let



,,, T

ii i

PPP P be the asset price vector at

the i date. We have the usual budget constraint T





u where 0u. The minimum variance program is the

usual convex minimization program that is perf ormed on

the rebalancing periods:

min





The variance covariance matrix V is calculated using

daily data from the historical window prior to the rebal-

ancing date.

Following Uryasev et al. (200 2), for the VAR and ex-

pected shortfall program with probability





0,1



 we

first define the function ()g



for a portfolio vector











() ,

gfya



 









 





where











is the β-quantile of the portfolio loss

distribution and







is the negative daily portfolio

return with portfolio vector x and portfolio daily re-

turns



1,, T

yy y. So we have









and









() min,aaRP





  where P(χ) is the

probability of







not exceeding the α threshold.

The daily portfolio returns are calculated from the port-

folio vector prices as a log returns.

The VAR and expected shortfall program is



min





where the optimization is performed on the rebalancing

periods 0,, t



. This setting of minimizing







is a problem of convex programming as





is con-

vex as a function of x and VAR and therefore differenti-

able in these variables. If ˆ



is the optimal portfolio

vector at the rebalancing date j then the VAR is









and the expected shortfall is





Finally the semivariance optimization program is ob-

tained similarly to the minimum variance optimization

but now instead of variance of returns, the partial mo-

ment of semivariance ([16]) is used. It is clear from the

above that on each rebalancing date three optimization

programs are performed and the optimal VM portfolio,

the min imu m V AR /E S po rtf ol io and th e mi ni mum S EM I

portfolio are obtained.

3. Data and Software

Four different data sets with only risky assets were con-

sidered and time series of closing prices spanning from

1/11/1997 to 3/3/2009 were used. The credit crunch pe-

riod was from 1/11/2007 to 3/3/2009 . The data sets were

composed of big capitalization stocks, listed in the Greek,

European and US market and two zero Greek govern-

ment coupon bonds with maturities of two and ten years.

Greek market has been chosen, because it is within the

euro area but still has emerging markets characteristics

like increased volatility, increased bid-offer spreads and

lack of depth compared to the core European markets

during periods of crises. Also the Greek bond market is

very suitable for this analysis because on the one hand it

is very liquid and is quoted on a spread to the German

bond market and on the other hand during the recent cri-

sis has been more damaged compared to other European

or American markets. Since in the analysis only risky

T. MAVRALEXAKIS ET AL.

assets are considered, Greek bonds used present a risky

class albeit of different nature from stocks. The bond

maturities used were capturing the most part of the yield

curve, and zero coupon were chosen so that the rein-

vestment coupon problem to be avoided.

Stocks with sufficient data history, which cover at

minimum the historical window, were grouped by their

national market and formed different data sets. The data

sets are the following: 1) 24 different time series of

stocks included in FTSE20 and FTSE40 Greek indexes;

2) 24 time series of stocks included in Dax30 Index; 3)

29 time series of stocks included in Dow 30 index and 4)

time series of ASE, Dax 30, Dow 30 indexes plus time

series of 10 years and 2 years Greek zero coupon bonds.

The formation of the objective function was based on

historical distribution and risk measures instead of risk

reward ratios (i.e. sharp ratios) were optimized. Keeping

the number of assumption to the minimum, rebalancing

frequencies, historical windows, risk measures, data

groups and short sales indicators were all variables to be

optimized during the credit crunch period.

During the credit crunch period rolling- window back-

-tests with a historical window of length H, and a holding

period of length F, were conducted. Overall, the time

evolution of 1440 different portfolios by using 4 histori-

cal windows, 9 rebalancing periods, 5 risk measures, 4

data groups and 2 short sales on/off indicators were

tested.

Each one of the different historical windows consid-

ered was of length 1 year, 2 years, 5 years and 10 years

and each one of the hold ing periods was of length 1 day,

1 week, 2 weeks, 1 month, 2 months, 3 months, 4 months,

5 months and 8 months.

Thus, at point in time 1

t, on data from 1



11t, optimization is performed with the resulting port-

folio to be held until 21

ttF . At this point, a new

optimal portfolio is computed, using data from 2



until 21t, and the existing portfolio is rebalanced. This

new portfolio is then held until 32

ttF and so on

and so forth until the end of the period. So during the

walk forward through the data, wealth trajectories are

computed optimizing each one of the above variables

considered and holding the others fixed. In order to per-

form the wealth trajectories through time, the initial port-

folio was set to contain only cash in amount of 100,000

EUR. No limits were imposed on the individual positions



. The optimal values for each of the above variables,

formed the selection criteria of the optimal portfolio to

be tested against indexing and equal weight strategies.

The software used for the computations was Matlab

R2007b. Optimizations were performed using sequential

quadratic programming methods (SQP), which transform

the constrained optimization problem into an easier sub-

problem that can then be solved and used as the basis of

an iterative process. Fmincon function capitalizes on this

method by solving the constrained problem using a se-

quence of parameterized quadratic programming uncon-

strained optimizations (more details about fmincon and

constraint non linear optimization exist in http://www.

mathworks.com).

4. Results

4.1. Risk Measures Performance

Interesting results were drawn concerning the choice of

the optimal risk measure, the optimal rebalancing period,

the optimal historical window and the usage or not of

short sales. The main result from the comparison of the

risk measures was that portfolios constructed by mini-

mizing partial and conditional moments like SEMI and

ES performed better than those constructed by simply

minimizing variance. Furthermore, when considered con-

fidence levels for the ES methodology, the optimal level

was the 95% and not 90% or 99% confidence levels.

Table 1 summarizes the findings where for each risk

measure the average portfolio value and the average an-

nual percentage change was calculated.

Table 1 shows that for the different risk measures the

portfolios performances are very close to each other with

that of SEMI being the optimal.

These findings suggest that during high volatility pe-

riods, like the credit crunch crisis, the optimal risk meas-

ure selection does not play such a crucial role. Next

finding was relative to the rebalancing frequency of the

portfolios. If a portfolio is never rebalanced, it will

gradually drift from its target asset allocation to higher-

return, higher-risk assets. Compared to the target alloca-

tion, portfolio’s expected return increases, as does its

vulnerability to deviations from the return of the target

asset allocation. Therefore there is a trade-off between

risk of return deviation and expected return deviation.

This trade off accounts for the cost of rebalancing, which

in this study is set to 30 basis points for buy transactions

and 70 basis points for sell transactions. Optimizations

with no transaction costs were run and it was found that

transaction costs did not significantly influence the re-

Table 1. Risk measures.

Risk Measure Portfolio Value Change

Variance 71.32% –22.59%

ES99% 71.89% –22.12%

ES95% 72.55% –21.58%

ES90% 72.11% –21.94%

Semivariance 74.45% –20.03%

T. MAVRALEXAKIS ET AL.

sults. Nevertheless as the portfolio was rebalanced more

frequently than usual (i.e. daily rebalancing), costs be-

came a bigger drag on performance.

Table 2 summarizes the findings, where for each re-

balancing period the average portfolio value and the av-

erage annual percentage change were calculated.

Table 2 shows that optimal rebalancing period is every

three months. Long rebalancing period were expected,

given the fact that the data set was coming from a

downward-trending market and therefore exhibited high

correlation. High correlated assets tend to move together

and eliminate the need for frequent rebalancing. Pliska

and Suzok [17] mention correlation, volatility and ex-

pected return as the asset class characteristics that influ-

ence the rebalancing strategy. Further studies also sug-

gest that market environment also plays a role. In trend-

ing markets rebalancing frequency should be decreased

as opposed to mean reverting markets where portfolio

rebalancing should be applied more often.

A third finding was relative to the use of the optimal

historical window H. Using the empirical distribution to

derive optimal portfolios means that every set of histori-

cal P/Ls forms a different set of scenarios. A large set of

scenarios with a long sample period produced distribu-

tions that better captured the reality including both high

and low volatility periods. On the other hand newer in-

formation in a sample is more informative than older one

and the longer the sample period is, the more periods

over which results distorted by past events are unlikely to

recur. Therefore there is a tradeoff between a large set of

scenarios and newer more relative information which

better capture the current situation. This tradeoff is ap-

parent in the findings given the fact that by using the

intermediate five year period the best portfolio perform-

ances were accomplished. Table 3 summarizes the find-

ings where for each historical window the average per-

centage portfolio value and the average annual percent-

Table 2. Rebalancing frequency.

Rebalancing Period Portfolio Value Change

1 day 52.33% –100%

1 week 72.20% –22.96%

2 weeks 74.72% –20.49%

1 month 76.12% –19.20%

2 months 75,46% –19.47%

3 months 76.53% –18.74%

4 months 75.41% –19.74%

5 months 75.37% –19.48%

8 months 70.58% –23.54%

Table 3. Historical window.

Historical Window Portfolio Value Change

1 year 73.66% –21.31%

2 years 7 3.58% –21.35%

5 years 73.74% –20.82%

10 years 68.87% –24.94%

age change was calculated.

As for the usage or not of short sales, it was found out

that by using short sales there was a marginal improve-

ment in the portfolio’s performances. Nevertheless the

volatility of the wealth trajectories of portfolios con-

structed with short sales was a lot bigger than the rest and

in some cases these portfolios even resulted losing all

their initial value. That’s short sales were excluded from

the selection criteria that formed the optimal portfolio.

Table 4 summarizes the findings.

4.2. Risk Measures and Benchmarks

Given the above results, the optimal minimum risk port-

folio was constructed without using short sales, with re-

balancing frequency of every three months and by using

five years of data to minimize the semivariance risk

measure. The wealth trajectories of this portfolio are

tested versus the wealth trajectories of benchmarks

formed from the four different data sets.

The benchmarks used for comparison were for the first

3 data sets (Greek equity market, European equity mar-

ket and US equity market) the relevant equity market

indexes and for all 4 data sets including the global data

set, which is not directly comparable with a specific

stock market index, the naïve equal weight strategy ([5]).

The results detailing the wealth trajectories of the opti-

mal portfolio versus the benchmarks for each data set are

presented in Tables 5, 6, 7 and 8.

From these tables (and the corresponding graphs 1

through 4) it is shown that the wealth trajectories formed

by the optimal portfolio clearly outperform the wealth

trajectories formed by the benchmarks.

Exception to this was the Greek market, where the

performances of the optimal portfolio and the perform-

ance of the benchm ark index were equal.

5. Conclusions

In this paper ex-ante minimum risk measures in various

Table 4. Short sales.

Short Sales Portfolio Value Change

No 73.66% –21.77%

Yes 73.58% –21.53%

Table 5. Greek market.

Rebalancing

Period Optimal

Portfolio Equal Weight General index

1 100,000 100,000 100,000

2 85064.78 76319.97 84489.76

3 81539.96 76265.07 79194.03

4 64165.71 61659.91 64529.23

5 38767.88 28842.23 38984.12

6 31639.11 25055.39 33293.54

T. MAVRALEXAKIS ET AL.

Table 6. Europe market.

Rebalancing

Period Optimal PortfolioEqual Weight 30DAX

1 100000 100000 100000

2 92153.45 88792.59 86179.51

3 92346.11 91484.52 87781.68

4 87570.46 84704.49 82019.79

5 87959.28 66777.33 60336

6 80073.42 67781.57 58496.55

Table 7. US market.

Rebalancing

Period Optimal PortfolioEqual Weight 30DOW

1 100000 100000 100000

2 92553.60 90036.49 90214.66

3 97774.04 94161.37 92411.87

4 99179.93 86102.95 82881.67

5 85140.55 67320.99 63047.37

6 81532.31 65328.67 59966.56

Table 8. Global.

Rebalancing Period Optimal Portfolio Equal Weight

1 100000 100000

2 99644.36 92279.67

3 99759.51 92201.97

4 99523.01 85227.92

5 100847.08 68399.73

6 102348.14 65903.66

Figure 1. Greek market.

Figure 2. German market.

Figure 3. US market.

Figure 4. Global market.

markets during the recent credit crunch crisis were tested.

Tests were also performed as far as the optimal rebal-

ancing portfolio period and the optimal historical win-

dow are concerned. After the optimal portfolios having

being produced, they were compared to the performance

of benchmarks indices in each market. The results ob-

tained are more or less the same for all markets. The op-

timal measure is the semivariance, the optimal rebalanc-

ing portfolio rebalancing period is three months and the

optimal historical period is five years. The performance

of the optimal portfolio clearly outperformed the bench-

marks. Inclusion of short sales did not add to the per-

formance even in a crisis period and the inclusion of

transaction costs seemed not to influence the perform-

ance of the optimal portfolios. Future directions can in-

clude derivatives portfolios and the study of risk meas-

ures under different volatility regimes (low volatility

periods with upward trending or mean-reverting markets).

In this way more effective tests could be performed and

further insight might be gained concerning correlation

among asset classes when structuring the optimal portfo-

lios.

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