Simplifying the Portfolio Optimization Process via Single Index Model

Yansen Ali June 2008 Industrial Engineering Honors Program McCormick School of Engineering Northwestern University Advisor Professor Sanjay Mehrotra Industrial Engineering and Management Sciences Northwestern University

Abstract Markowitz (1959) is one of the pioneers of modern portfolio theory. Since he introduced the basic portfolio optimization model as early as 1956, there had been numerous advances of the portfolio theory. However, putting the theory into practice remains a challenging area for practitioners as financial system and settings become more sophisticated. This paper will look into the single index model as one potential solution to simplify the calculation of optimal portfolios and examine its effectiveness under different settings of the model.

Abstract
Introduction Markowitz Model Single Index Model Method 1 Unadjusted beta Method 2 Blumes beta Method 3 Vasiceks beta Solution Approach Results & Analysis Conclusions Acknowledgement Appendices

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3 3 5 6 6 7 8 9 12 12 13

References

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Introduction Portfolio optimization has been a highly researched area in operations research. This paper will attempt to apply one of the foundations in portfolio optimization, the Markowitz portfolio selection model (Markowitz, 1959) to solve real world problems based on the daily returns data of 48 different industries. While the optimization model used here is limited in its scope and complexity, the paper will mostly focus on methods of implementing the Markowitz model. Thus, the main objective of this paper is to gain important insights on how to develop an effective computational procedure to determine optimal portfolios. The performance of the resulting portfolios will then be compared with the industrial standard returns from Dow Jones AIG Commodity Index (DJ-AIGCI). One of the main components in the inputs to portfolio analysis is the correlation structure of the stocks. When the number of stocks to select from the portfolio is large, the estimation of the covariance can get very impractical for computation purposes. This project will look into the single index model which was discussed comprehensively by Elton and Gruber (1987) and analyze its applicability in solving the Markowitz optimization model using real world data. The data used in this project are the daily average-value weighted returns of 48 different industries collected from Kenneth R. French Data Library. For complete breakdown of the 48 industries, please refer to Appendix I. The average value-weighted return is simply the weighted average of all stock returns, with the weights given by the market value of the stock (price times shares outstanding) at the end of the previous trading period. The input data points include 3553 daily returns data and the period starts from 01/04/1988 to 12/31/2001 (see Appendix II). The performance measures are the difference in returns by Markowitz model and the Dow Jones returns. The non-parametric pair sign test will provide the required statistical analysis as the data of difference in returns will later be found to be not normally distributed. Additionally, some parameters of the Markowitz model will be customized to provide a broader view on the performance analysis of the single index model as a method of forecasting the correlation structures for portfolio optimization.

Markowitz Model The basic solution approach to this problem is to implement the Markowitz model in finding an optimal portfolio selection in each forecast period. There are two objectives behind Markowitz model; to achieve high returns and to achieve stable returns with low uncertainty. In my model, the objective function is to maximize total returns, constrained by maximum allowable risk level. The Markowitz optimization model can be modeled as follows:
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Inputs ri = return on industry i k = maximum risk factor

covij = covariance between industry i and j

N = portfolio size (number of industries)

Decision Variables
x j = fraction of portfolio to invest in industry j

Objective Maximize Total Returns: Constraints Budget constraint:

r x
i iI

x
i I

Maximum allowable risk:

x
iI jJ

cov ji xi

k N

The project used historical data to estimate the inputs to Markowitz model. These inputs require estimates of the expected return on each stock ri and the covariance between each possible pair of stocks for the stocks under consideration. The estimation can get very complex as the portfolio size becomes large. For instance, if the number of stocks in a portfolio is 48, as in our case, we need to estimate N*(N-1)/2 = (48*47)/2 = 1128 correlation coefficients. The large number of inputs can be computationally impractical due to the large number of estimates that have to be made. Part of the project was to develop a more efficient estimation model and assess its performance in terms of total returns created. For this objective, single index model was applied to simplify the inputs to the Markowitz model.
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Single index model

Single index model assumes that the co-movement between stocks is due the single common influence by market performance. Hence, the measure of this index can be found by relating the stock return to the return on a stock market index. The formulation for single index model can be shown below:

ri = ai + i rm
where ri = return on stock i ai = component of stock is return that is independent of the markets performance rm = the rate of return on the market index

i = a constant that measures the expected change in ri given a change in rm

The term ai can be further broken down into i and ei where i is the expected value of ai and ei is the random element of ai . The expected return, variance and covariance can be estimated as follows when they are used to represent the joint movement of stocks: Mean return of stock, r i = i + i r m
2 2 Variance of a stocks return, i2 = i2 m + ei

2 Covariance of returns between stocks i and j, ij = i j m 2 2 where m = market variance and ei =unique risk factor

The single index model will need the estimates of mean return, variance of return and the beta for each stock, which amounts to 3N + 2 = (3*48 + 2) = 146 estimates, in our case of 48 industries. This is much easier to compute than the previously mentioned estimates of 1128 correlation coefficients. For the purpose of the Markowitz model, I estimated the mean return of
2 each industry, ri and the market variance, m by calculating the average industry returns and

variance of market returns over a specified period, respectively. Finally, we need to estimate beta
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for each stock in order to calculate the covariance needed in the Markowitz model. Beta is simply a measure of sensitivity of stock to market movement. There are 3 methods of estimating beta as forecasters of covariance: 1) Forecasts of covariance by estimating betas from prior historical period (unadjusted beta) 2) Forecasts of covariance by estimating betas from the prior two periods and updating via Blumes technique (Blumes beta) 3) Forecasts of covariance by estimating betas from prior historical period and updating via Vasiceks technique (Vasiceks beta)

Method 1: Unadjusted beta

The first method simply estimates betas from historical data. The historical beta for each stock i can be obtained through regression analysis of stock return rit against market return rmt from a past period, t = 1 to t = T. The calculation of beta for each stock is formally shown below. The estimation of historical beta is subjected to error and might deviate significantly from actual beta since actual beta is not perfectly stationary over time. The betas might change significantly from one period to another and large random error may lead to substantial forecasting error.

i = im = 2 m

[(r
t =1

it

rit rmt rmt

mt

)(

)]

(r
t =1

rmt

Method 2: Blumes beta

Blumes analysis on the behavior of betas over time shows that there is a tendency of actual betas in the forecast period to move closer to one than the estimated betas from historical data. Blumes technique attempts to describe this tendency by correcting historical betas to adjust the betas towards one, assuming that adjustment in one period is a good estimate in the next period. Consider betas for all stocks i in period 0, i 0 and betas for the same stocks i in the successive period 1, i1 . The betas for period 1 are then regressed against the betas for period 0 to obtain the following equation:
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 i 1 = k1 + k 2 i 0
The relationship implies that the beta in period 1 is k1 + k2 times the beta in the period 0. Therefore, if i1 is A, the estimate of beta in the next period i 2 will be (k1+ k2*A) instead of A. This adjustment sets the average beta to undergo similar trend for subsequent forecast periods. If there is an increasing trend in average beta for period 1, average beta for period 2 will consequently increase. This might not reflect the actual beta movement from one period to another. Hence, Blume further modifies the average beta towards historical mean. This is done by first calculating the average beta of all stocks for period 1 and 2, 1 and 2 . To adjust the mean of the forecasted beta towards historical mean, the new forecast of beta for each stock i

i 2 is obtained by subtracting 2 from the previously forecast of beta and adding 1 .

Method 3: Vasiceks beta

As mentioned earlier, the average beta tends to move towards one over time. Another method to capture this tendency is via Vasiceks technique. Vasiceks technique adjusts past betas towards the average beta by modifying each beta depending on the sampling error about beta. When the sampling error is large, there is higher chance of larger difference from the average beta. Therefore, lower weight will be given to betas with larger sampling error. The following formula demonstrates this idea:
2 2 1 1i + 2 i 2 = 2 2 2 1 + 1i 1 1 + 1i i1

where

i 2 = forecast of beta for stock i for period 2 (later period) 1 = average beta across the sample of stocks in period 1 (earlier period)
2 1 = variance of the distribution of historical estimates of beta across the sample

of stocks

i1 = estimate of beta for stock i in period 1

2 1i = variance of the estimate of beta for stock i in period 1

Solution Approach
The goal in this project is to assess the performance of Markowitz portfolio optimization model under different scenarios summarized below. 1) Find the optimal portfolio selection for different risk levels (risk factor k). 2) Find the optimal portfolio selection for each rolling period from 01/04/1988 to 12/31/2001. There is a total of 3443 periods with each rolling period consisting of 90 days. I added transaction cost in linear terms as an extension to the Markowitz model shown below. Inputs ri = return of industry i k = maximum risk factor

covij = covariance between industry i and j

N = portfolio size (number of industries) x0 i = fraction of the original portfolio invested in industry i in the previous period t = transaction cost (in percentage)

Decision Variables xi = fraction of portfolio to invest in industry i yi = amount of long transaction in industry i zi = amount of short transaction in industry i

Objective Maximize Total Returns: Constraints Budget constraint:

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r x
i iI

t * ( yi + zi )
iI

x
i I

Maximum allowable risk:

x
iI jJ

cov ji xi

k N

Buying constraint xi - x 0 i y i
i I

Selling constraint
x 0 i - xi zi i I

3) Apply the three different methods of estimating beta (Unadjusted/Historical beta, Blumes beta and Vasiceks beta) in single index model as inputs to the Markowitz model.

Results and Analysis

I present three sets of results that display the difference between the returns based on Markowitz model and the returns of Dow Jones - AIG Commodity Index (DJ-AIGCI). The Markowitz portfolio selections were obtained by solving the portfolio optimization problems for 3443 periods from 01/04/1988 to 08/16/2001. Each rolling period consists of 90 days, which means that we have to estimate the betas and expected returns using 90-day data for each period. The portfolio solutions will be used to decide which industry and what amount to invest in each industry on the 91st day. The forecast period starts from 05/11/1988 to 12/28/2001 and the model was run with risk factors k = 1, 1.5, 2, 2.5, 3, 3.5 and 4. I repeated the same procedure for the three methods of beta estimation in single index model (unadjusted beta, blumes beta and vasiceks beta). The Dow Jones return indexes were selected as the benchmark because they provide diversification, liquidity, stability and weightings that indicate economic significance. Thus, DJ-AIGCI is a reliable source of comparison with our model even though it does not have identical commodities as the 48-industries portfolio. I calculated the paired difference between returns based on the Markowitz model and the Dow Jones index returns and performed paired sign test to test for a difference between the two means of returns. The non-parametric paired sign test (function signtest.m on Matlab) was used
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instead of the paired t-test because the distribution of the difference between two means is not normally distributed and is extremely heavy tailed, as depicted in the Q-Q plots in Appendix VII. The first set of result in table 1 gives the summary statistics of the difference between returns of Markowitz model using unadjusted beta and Dow Jones returns (Markowitz returns Dow Jones returns) with different risk factor k. The paired sign test tests the null hypothesis that the median of the differences in the pairs is zero. The results show positive mean difference of returns for all risk factors k. However, these results are not significant as all the hypothesis tests based on paired sign test give H = 0, which means that null hypothesis cannot be rejected at 0.05 % significant level. All the tests conclude that there is no significant difference between the returns by our model for all risk levels and the Dow Jones returns (high p-values). We can see slight increase in the mean difference of returns and decrease in p-values as the risk levels increase from 1 to 4.

Table 1: Summary Statistics of Paired Sign Test for Difference between Returns by Markowitz model with Unadjusted beta and Dow Jones returns
Risk factor , k 2 2.5 3 0.0320 0.0322 0.0315 0 0 0 0.321 0.303 0.222 1347 1346 1341 0.99 1.03 1.22

Statistic Mean Diff H p-value Test Statistic Z-value

1 0.0136 0 0.620 1360 0.50

1.5 0.0257 0 0.303 1346 1.03

3.5 0.0335 0 0.109 1331 1.60

4 0.0335 0 0.109 1331 1.60

Table 2 analyzes the difference between returns by Markowitz model with blumes beta and Dow Jones returns. There is no significant difference between the returns by Markowitz model with blumes beta and Dow Jones returns for all risk factors k. The mean difference of returns is increasing with risk level while the p-values decrease with risk level. For k = 4, the pvalue is fairly low (0.093), which indicates that at 0.1 % significant level, we can assume that the returns of the Markowitz model are greater than the Dow Jones returns.

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Table 2: Summary Statistics of Paired Sign Test for Difference between Returns by Markowitz model with Blumes beta and Dow Jones returns
Risk factor , k 2 2.5 3 0.0348 0.0352 0.0343 0 0 0 0.268 0.237 0.194 1344 1342 1339 1.11 1.18 1.30

Statistic Mean Diff H p-value Test Statistic Z-value

1 0.0145 0 0.593 1359 0.53

1.5 0.0255 0 0.268 1344 1.11

3.5 0.0345 0 0.170 1337 1.37

4 0.0360 0 0.093 1329 1.68

The third set of result is displayed in table 3 where a comparison between the returns by Markowitz model with vasiceks beta and Dow Jones returns is made. Again, there is no significant difference between the returns by Markowitz model and the Dow Jones returns for all risk levels. There is also some variation on the mean differences and the p-values for different risk levels.

Table 3: Summary Statistics of Paired Sign Test for Difference between Returns by Markowitz model with Vasiceks beta and Dow Jones returns
Risk factor , k 2 2.5 3 0.0285 0.0292 0.0283 0 0 0 0.285 0.237 0.285 1345 1342 1345 1.07 1.18 1.07

Statistic Mean Diff H p-value Test Statistic Z-value

1 0.0127 0 0.647 1361 0.46

1.5 0.0192 0 0.492 1355 0.69

3.5 0.0297 0 0.285 1345 1.07

4 0.0313 0 0.147 1335 1.45

Overall, there is no significant difference between returns based on the Markowitz model and the returns by Dow Jones. Further modification to the Markowitz model needs to be done to improve the performance and the relevance of portfolio optimization model to handle the real world data. Nevertheless, the study is able to provide some insights on the effectiveness of the single-index model to estimate the inputs to the model. The results indicate that the Markowitz model with inputs based on single-index model is able to produce comparable returns with DJAIGCI. Moreover, out of the three methods to estimate beta for single index model, blumes technique appears to give the best result with highest mean difference in returns and lowest pvalues. The increasing trend in returns as risk factor increases is also more evident in Markowitz returns with blumes beta. Hence, if we use blumes beta to calculate the inputs to the Markowitz optimization model, we are more likely to get significantly higher returns than the Dow Jones returns.
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Conclusions
After completing the study on the computational method in portfolio analysis, I was able to conclude that the single index model worked well in estimating the inputs to the basic Markowitz optimization model. This is shown by the comparable returns produced by the Markowitz model and Dow Jones AIG-Commodity Index. Although the comparison is not completely accurate as their portfolio stocks are not wholly identical, the Dow Jones returns data are still useful to reflect economic influence. Also, it is shown that blumes technique worked better than the other two methods to estimate beta in single index model. There are certainly areas of improvement in this project, especially in the development of more advanced extension to the Markowitz optimization model. The current simplistic model can be the reason why the portfolio selection is small for all cases; the optimal portfolio only selects a maximum of 2 industries in all periods (see Appendix V). This paper has also not looked in depth for potential biases in the single index model, which might affect the end results. From this project, I found that computational procedure can get as complicated as formulating a solution method, especially when large scale data is involved. It is imperative that one plans a robust and systematic method in solving a theoretical model. When the right method is applied, it can lead to a better utility of the model and more efficient implementations.

Acknowledgement
I would like to thank Prof Sanjay Mehrotra for all his help and guidance throughout the project and Michael Chen, Northwestern University for finding me the required data and going through the basic of portfolio analysis with me.

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Appendices Appendix I: Breakdown of the 48 Industries

Refer to Excel Spreadsheet

Source: Kenneth R. French Data Library, 2007

Appendix II: Daily Average Value Weighted Returns for 48 Industries

Refer to Excel Spreadsheet

Source: Kenneth R. French Data Library, 2007

Appendix III: Markowitz Model Formulation in Ampl

set Industry;

param k > 0, default 1; param varM; param beta {Industry};

# maximum risk factor # market variance # beta for each industry

param x0{Industry} >= 0, default 0; param t > 0, default 0.005 ;

#investment in the previous period # transaction cost

param cov {i in Industry,j in Industry} = beta[i]*beta[j]*varM; # Calculate covariance param m {Industry}; # mean return of random variable r

var x{Industry} >= 0, <= 1; var y{Industry} >= 0; var z{Industry} >= 0;

# fraction of portfolio to invest in Industry i

maximize returns: sum{i in Industry}( m[i] *x[i] - t*(z[i]+y[i]) );

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subject to risk:sum{i in Industry, j in Industry} x[j]*cov[j,i]*x[i] <= k/48; subject to budget:sum{i in Industry} x[i] <= 1; subject to buy {i in Industry}:x[i] - x0[i] <= y[i]; subject to sell{i in Industry}:x0[i] - x[i] <= z[i];

Appendix IV: Inputs to Markowitz Model

Refer to Excel Spreadsheet

These data include expected return for each industry, market variance and 3 types of beta inputs (unadjusted beta, blumes beta, vasiceks beta) for each period. Note that each rolling period consists of 90 days. The period column in the Excel spreadsheet will only indicate the 1st day of the rolling period.

Appendix V: Portfolio Size

Refer to Excel Spreadsheet

These outputs show how many stocks the portfolio model decides to invest in for each period and for all three types of beta inputs.

Appendix VI: Returns based on the Markowitz Portfolio Selection

Refer to Excel Spreadsheet

These outputs are the returns based on the Markowitz Portfolio selection for all three types of beta inputs and all risk factors k. The Dow Jones returns are also shown here.

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Appendix VII: Q-Q plots of difference between returns based on the Markowitz model and the Dow Jones index returns
The plots show similar pattern where the distribution is not normally distributed and heavy tailed. These plots also include all returns with different risk factor k.

Fig 1: Returns under Unadjusted beta Dow Jones Returns

Fig 2: Returns under Blumes beta Dow Jones Returns

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Fig 3: Returns under Vasiceks beta Dow Jones Returns

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References
"Dow Jones AIG-Commodity Index." Dow Jones Indexes. 2008. Dow Jones. <http://www.djindexes.com/mdsidx/index.cfm?event=showAigDataCharts>.

Elton, Edwin J., and Martin J. Gruber. Modern Portfolio Theory and Investment Analysis. 3rd ed. John Wiley & Sons, 1987. 95-128.

Fourer, Robert, David M. Gay, and Brian W. Kernighan. AMPL: a Modeling Language for Mathematical Programming. 2nd ed. Thomson - Brooks/Cole, 2003.

French, Kenneth R. "Data Library." Kenneth R. French. 2007. <http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html>.

Markowitz, Harry M. Portfolio Selection: Efficient Diversification of Investments. John Wiley & Sons, New Jersey, 1959.

"Two-Sample Paired Sign Test." PROPHET StatGuide. Northwestern University Medical School. <http://www.basic.northwestern.edu/statguidefiles/sign_paired.html>.

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