Robust Equity Portfolio Management + Website

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3 Robust Equity Portfolio Management + Website

4 The Frank J. Fabozzi Series Fixed Income Securities, Second Edition by Frank J. Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James A. Abate Handbook of Global Fixed Income Calculations by Dragomir Krgin Managing a Corporate Bond Portfolio by Leland E. Crabbe and Frank J. Fabozzi Real Options and Option-Embedded Securities by William T. Moore Capital Budgeting: Theory and Practice by Pamela P. Peterson and Frank J. Fabozzi The Exchange-Traded Funds Manual by Gary L. Gastineau Professional Perspectives on Fixed Income Portfolio Management, Volume 3 edited by Frank J. Fabozzi Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi and Efstathia Pilarinu Handbook of Alternative Assets by Mark J. P. Anson The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry The Handbook of Financial Instruments edited by Frank J. Fabozzi Interest Rate, Term Structure, and Valuation Modeling edited by Frank J. Fabozzi Investment Performance Measurement by Bruce J. Feibel The Handbook of Equity Style Management edited by T. Daniel Coggin and Frank J. Fabozzi The Theory and Practice of Investment Management edited by Frank J. Fabozzi and Harry M. Markowitz Foundations of Economic Value Added, Second Edition by James L. Grant Financial Management and Analysis, Second Edition by Frank J. Fabozzi and Pamela P. Peterson Measuring and Controlling Interest Rate and Credit Risk, Second Edition by Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry Professional Perspectives on Fixed Income Portfolio Management, Volume 4 edited by Frank J. Fabozzi

5 The Handbook of European Fixed Income Securities edited by Frank J. Fabozzi and Moorad Choudhry The Handbook of European Structured Financial Products edited by Frank J. Fabozzi and Moorad Choudhry The Mathematics of Financial Modeling and Investment Management by Sergio M. Focardi and Frank J. Fabozzi Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi The Real Estate Investment Handbook by G. Timothy Haight and Daniel Singer Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy SecuritiesFinance: SecuritiesLending and Repurchase Agreements edited by Frank J. Fabozzi and Steven V. Mann Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev, Christian Menn, and Frank J. Fabozzi Financial Modeling of the Equity Market: From CAPM to Cointegration by Frank J. Fabozzi, Sergio M. Focardi, and Petter N. Kolm Advanced Bond Portfolio Management: Best Practices in Modeling and Strategies edited by Frank J. Fabozzi, Lionel Martellini, and Philippe Priaulet Analysis of Financial Statements, Second Edition by Pamela P. Peterson and Frank J. Fabozzi Collateralized Debt Obligations: Structures and Analysis, Second Edition by Douglas J. Lucas, Laurie S. Goodman, and Frank J. Fabozzi Handbook of Alternative Assets, Second Edition by Mark J. P. Anson Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis, and Moorad Choudhry Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, Frank J. Fabozzi, Sergio M. Focardi, and Teo Jasic Developments in Collateralized Debt Obligations: New Products and Insights by Douglas J. Lucas, Laurie S. Goodman, Frank J. Fabozzi, and Rebecca J. Manning Robust Portfolio Optimization and Management by Frank J. Fabozzi, Peter N. Kolm, Dessislava A. Pachamanova, and Sergio M. Focardi Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizations by Svetlozar T. Rachev, Stogan V. Stoyanov, and Frank J. Fabozzi

6 How to Select Investment Managers and Evaluate Performance by G. Timothy Haight, Stephen O. Morrell, and Glenn E. Ross Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, Biliana S. Bagasheva, and Frank J. Fabozzi The Handbook of Municipal Bonds edited by Sylvan G. Feldstein and Frank J. Fabozzi Subprime Mortgage Credit Derivatives by Laurie S. Goodman, Shumin Li, Douglas J. Lucas, Thomas A Zimmerman, and Frank J. Fabozzi Introduction to Securitization by Frank J. Fabozzi and Vinod Kothari Structured Products and Related Credit Derivatives edited by Brian P. Lancaster, Glenn M. Schultz, and Frank J. Fabozzi Handbook of Finance: Volume I: Financial Markets and Instruments edited by Frank J. Fabozzi Handbook of Finance: Volume II: Financial Management and Asset Management edited by Frank J. Fabozzi Handbook of Finance: Volume III: Valuation, Financial Modeling, and Quantitative Tools edited by Frank J. Fabozzi Finance: Capital Markets, Financial Management, and Investment Management by Frank J. Fabozzi and Pamela Peterson-Drake Active Private Equity Real Estate Strategy edited by David J. Lynn Foundations and Applications of the Time Value of Money by Pamela Peterson-Drake and Frank J. Fabozzi Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds, Loans, and Derivatives by Stephen Antczak, Douglas Lucas, and Frank J. Fabozzi Modern Financial Systems: Theory and Applications by Edwin Neave Institutional Investment Management: Equity and Bond Portfolio Strategies and Applications by Frank J. Fabozzi

7 Robust Equity Portfolio Management + Website Formulations, Implementations, and Properties Using MATLAB WOO CHANG KIM JANG HO KIM FRANK J. FABOZZI

8 Copyright 2016 by Woo Chang Kim, Jang Ho Kim, and Frank J. Fabozzi. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) , fax (978) , or on the Web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) , fax (201) , or online at Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) , outside the United States at (317) or fax (317) Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at For more information about Wiley products, visit Library of Congress Cataloging-in-Publication Data Names: Kim, Woo Chang. Kim, Jang-Ho. Fabozzi, Frank J. Title: Robust equity portfolio management + website : formulations, implementations, and properties using MATLAB / Woo Chang Kim, Jang Ho Kim, Frank J. Fabozzi. Description: Hoboken : Wiley, Series: Frank J. Fabozzi series Includes index. Identifiers: LCCN ISBN (hardback) ISBN (epdf) ISBN (epub) Subjects: LCSH: Porffolio management. Investments Mathematical models. Investment analysis Mathematical models. BISAC: BUSINESS & ECONOMICS / Investments & Securities. Classification: LCC HG K DDC /53 dc23 LC record available at Cover Design: Wiley Cover Image: Danil Melekhin/Getty Images, Inc. Printed in the United States of America

9 WCK To my daughter, Joohyung JHK To my wife, Insun Jung FJF To my sister, Lucy

11 Contents Preface xi CHAPTER 1 Introduction 1 CHAPTER 2 Mean-Variance Portfolio Selection 6 CHAPTER 3 Shortcomings of Mean-Variance Analysis 22 CHAPTER 4 Robust Approaches for Portfolio Selection 39 CHAPTER 5 Robust Optimization 66 CHAPTER 6 Robust Portfolio Construction 95 CHAPTER 7 Controlling Third and Fourth Moments of Portfolio Returns via Robust Mean-Variance Approach 122 CHAPTER 8 Higher Factor Exposures of Robust Equity Portfolios 137 CHAPTER 9 Composition of Robust Portfolios 164 CHAPTER 10 Robust Portfolio Performance 185 ix

12 x CONTENTS CHAPTER 11 Robust Optimization Software 216 About the Authors 231 About the Companion Website 233 Index 235

13 Preface The mean-variance model for constructing portfolios, introduced by Harry Markowitz, changed how portfolio managers analyze portfolios, especially for managing equity portfolios. The model provides a strong foundation for quantifying the return and risk attributes of a portfolio, as well as mathematically forming optimal portfolios. Following the 1952 publication of Markowitz s mean-variance model, there have been numerous extensions of the original model, particularly starting in the 1990s, that have sought to overcome criticisms of the original model. In this book, we focus on one of these extensions, the construction of robust portfolios for equity portfolio management within the mean-variance framework. We refer to this approach as robust equity portfolio management. The book will be most helpful for readers who are interested in learning about the quantitative side of equity portfolio management, mainly portfolio optimization and risk analysis. Mean-variance portfolio optimization is covered in detail, leading to an extensive discussion on robust portfolio optimization. Nonetheless, readers without prior knowledge of portfolio management or mathematical modeling should be able to follow the presentation, as basic concepts are covered in each chapter. Furthermore, the main quantitative approaches are presented with MATLAB examples, allowing readers to easily implement portfolio problems in MATLAB or similar modeling software. An online appendix provides the MATLAB codes presented in the chapter boxes ( Although this is not the only book on robust portfolio management, it distinguishes itself from other books by focusing solely on quantitative robust equity portfolio management, including step-by-step implementations. Other books, such as Robust Portfolio Optimization and Management by Frank J. Fabozzi, Petter N. Kolm, Dessislava Pachamanova, and Sergio M. Focardi, also introduce robust approaches, but we believe that readers seeking to learn the formulations, implementations, and properties of robust equity portfolios will benefit considerably by studying the chapters in the current book. Woo Chang Kim Jang Ho Kim Frank J. Fabozzi xi

15 CHAPTER 1 Introduction The foundations of what is popularly referred to as modern portfolio theory is attributable to the seminal work of Harry Markowitz, published more than a half a century ago. 1 Markowitz provided a framework for the selection of securities for portfolio construction to obtain an optimal portfolio. To do so, Markowitz suggested that for all assets that are candidates for inclusion in a portfolio, one should measure an asset s return by its mean return and risk by an asset s variance of returns. In the selection of assets to include in a portfolio, the Markowitz framework takes into account the co-movement of asset returns by using the covariance between all pairs of assets. The portfolio s expected return and risk as measured by the portfolio variance are then determined by the weights of each asset included in the portfolio. For this reason, the Markowitz framework is commonly referred to as mean-variance portfolio analysis. Markowitz argued that the optimal portfolio should be selected based on the trade-off between a portfolio s return and risk. While these concepts are considered the basis of portfolio construction these days, the development of the mean-variance model shaped how investment managers analyze portfolios and sparked an overwhelming volume of research on the theory of portfolio selection. Once the fundamentals of modern portfolio theory were established, studies addressing the limitations of mean-variance analysis appeared, seeking to improve the effectiveness of the original model under practical situations. Some research efforts concentrated on reducing the sensitivity of portfolios formed from mean-variance analysis. Portfolio sensitivity means that the resulting portfolio constructed using mean-variance analysis and its performance is heavily dependent on the inputs of the model. Hence, if the estimated input values were even slightly different from their true values, the estimated optimal portfolio will actually be far from the best choice. This is especially a drawback when managing equity portfolios because the equity market is one of the more volatile markets, making it difficult to estimate values such as expected returns. In equity portfolio management, there has been increased interest in the construction of portfolios that offer the potential for more robust performance even during more volatile equity market periods. One common 1

The Basics of Finance

The Basics of Finance The Frank J. Fabozzi Series Fixed Income Securities, Second Edition by Frank J. Fabozzi Focus on Value: A Corporate and Investor Guide to Wealth Creation by James L. Grant and James