INQUIREUK Presentation

Inquire UK
Autumn Seminar
22-24 September 2002
Royal Bath Hotel, Bournemouth
Portfolio Selection
with Higher Moments
Campbell R. Harvey
Duke University, Durham, NC USA
National Bureau of Economic Research, Cambridge, MA USA
http://www.duke.edu/~charvey
1. Objectives
• The asset allocation setting

• What is risk?
• Conditional versus unconditional risk
• The importance of higher moments
• Estimation error
• New research frontiers
Campbell R. Harvey 2
2. Modes/Inputs of Asset Allocation
• Types of asset allocation

– Strategic
– Tactical
• Type of information
– Unconditional
– Conditional
Constant Dynamic
weights Slow evolving weights
weights
Strategic Tactical
Unconditional Conditional
• Conditioning information makes a

difference
3. Performance Depends on Business Cycle
Average Annual Returns During U.S. Business Cycle Phases
30
20
10
-10
-20
-30
Sw Swe ain
Ca ium
ex ld
Fr and
or W S
lg a
nd
N J ly
Sp al
Ita d
A alia
Ire ong
K
a s
ew rl n
rtu y
it z den
FE
Fi ark
g ny
H erm ce
EA S
en a
N l and
Be stri
Ze and
U
D nad
N the apa
Po rwa
ld or
-U
g
U
la
la
G an
on a
nl
m
tr
er
u
o
us
A
W
Expansion geometric mean Recession geometric mean
Data through June 2002 Campbell R. Harvey 6
A
us
tr
0
10
20
30
40
50
60
A alia
u
Data through June 2002

Be stri
lg a
Ca ium
D nad
en a
m
Fi ark
nl
Fr and
G an
H erm ce
on a
g ny
K
Ire ong
la
n
Ita d
Expansion std.dev.
N J ly
e
N the apa
ew rl n
Ze and
a s
N l and
or
Po wa
Campbell R. Harvey
rtu y
g
Sp al
Sw Swe ain
it z de
er n
Recession std.dev. la
nd
U
K
W U
or W S
ld or
ex ld
-U
EA S
FE
Average Annual Volatility During U.S. Business Cycle Phases
7
Correlations During U.S. Business Cycle Phases
1
0.8
0.6
0.4
0.2
-0.2
Sw Swe ain
Ca ium
ex ld
Fr and
or W S
lg a
nd
N J ly
Sp al
Ita d
A alia
Ire ong
K
a s
ew rl n
rtu y
er n
FE
Fi ark
g ny
H erm ce
EA S
en a
N l and
Be stri
Ze and
U
D nad
N the apa
Po wa
it z de
ld or
-U
g
U
la
la
G an
on a
nl
m
tr
K
u
or
us
A
W
Expansion correlation with US Recession correlation with US
Covariances During U.S. Business Cycle Phases
45
40
35
30
25
20
15
10
5
0
Sw Swe ain
Ca ium
ex ld
Fr and
or W S
lg a
nd
N J ly
Sp al
Ita d
A alia
Ire ong
K
a s
ew rl n
rtu y
it z den
FE
Fi ark
g ny
H erm ce
EA S
en da
N l and
Be stri
Ze and
U
N the apa
Po wa
ld or
-U
g
U
la
la
G an
D na
on a
nl
m
tr
er
u
or
us
A
W
Expansion covariance with US Recession covariance with US
4. Conditioning Information and Portfolio
Analysis
• Adding conditioning information is like

adding extra assets to an optimization
Analysis
Er
Traditional fixed weight

optimization (contrarian)
in 2-dimensional setting
Vol
Analysis
Er Add conditioning
information and weights
change through time.
Frontier shifts.
Vol
5. What is Risk?
• Traditional models maximize expected

returns for some level of volatility
• Is volatility a complete measure of risk?
5. What is Risk?
• Much interest in downside risk, asymmetric

volatility, semi-variance, extreme value
analysis, regime-switching, jump processes,
...
6. Skewness
• ... These are just terms that describe the

skewness in returns distributions.
• Most asset allocation work operates in two
dimensions: mean and variance -- but skew
is important for investors.
• Examples:
6. Skewness
1. The $1 lottery ticket. The expected value is

$0.45 (hence a -55%) expected return.
– Why is price so high?
– Lottery delivers positive skew, people like
positive skew and are willing to pay a premium
6. Skewness
2. High implied vol in out of the money OEX

put options.
– Option limits downside (reduces negative
skew).
– Investors are willing to pay a premium for
assets that reduce negative skew
6. Skewness
2. High implied vol in out of the money S&P index

put options.
– This example is particularly interesting because the
volatility skew is found for the index and for some large
capitalization stocks that track the index – not in every
option
– That is, one can diversify a portfolio of individual
stocks – but the market index is harder to hedge.
– Hint of systematic risk
6. Skewness
3. Some stocks that trade with seemingly

“too high” P/E multiples
– Enormous upside potential (some of which is
not well understood)
– Investors are willing to pay a premium for
assets that produce positive skew
– [Note: Expected returns could be small or
negative!]
7. Skewness
3. Some stocks that trade with seemingly

“too high” P/E multiples
– Hence, traditional beta may not be that
meaningful. Indeed, the traditional beta may be
high and the expected return low if higher
moments are important
7. Skewness
12.5
Expected Return 10 2
7.5
1
5
0 0
Skewness
5
- 1
Variance 10
- 2
15
7. Skewness
RF
12.5
Expected Return 10 2
7.5
1
5
0 0
Skewness
5
-1
Variance 10
-2
15
7. Skewness
2
0 Skewness
-1
RF
-2
12.5
10
Expected Return
7.5
5
10 15
0 5
Variance
7. Skewness
15
10
Variance
12.5
5 10
7.5 Expected Return
5
2 RF
1
0
Skewness - 1
-2
7. Skewness
Skewness Variance
-1 -20
0 5
2 1 10 15
12.5
10 RF
Expected Return
7.5
7. Higher Moments & Expected Returns
• CAPM with skewness invented in 1973 and

1976 by Rubinstein, Kraus and Litzerberger
• Same intuition as usual CAPM: what counts
is the systematic (undiversifiable) part of
skewness (called coskewness)
• Covariance is the contribution of the

security to the variance of the well
diversified portfolio
• Coskewness is the contribution of the
security to the skewness of the well
diversified portfolio
A
us
t
0.5
1.5
-2
-1
0
1
2
-2.5
-1.5
-0.5

A ralia
u
Be stri
lg a
Ca ium
D na
en da
m
Fi ark
nl
Fr and
G a
H erm nce
on a
g ny
K
Ire ong
la
n
Ita d
N J ly
N ethe apa
ew rl n
Ze and
a s
N l an
or d
Campbell R. Harvey
Po wa
rtu y
g
Sp al
Sw Swe ain
it z de
er n
la
n
Ud
K
W U
or W S
ld or
Average Skewness in Developed Markets
ex ld
-
EAUS
FE
28
A
rg
e
-2.5
-1.5
-0.5
0.5
1.5
-2
-1
0
1
2
Banti n
hr a
Br a in
a
Chz il

Cz i
e c Co Chi l e
h lo na
Re m
pu bia
Egbl ic
G yp
H ree t
un c e
ga
In In ry
do di
ne a
Is sia
Jo rae
rd l
M Ko an
ala re
a
M ysi a
M ex
or ic o
o
N cco
ig
er
Pa Om i a
ki an
Ph sta n
ili Pe
pp ru
i
Campbell R. Harvey
Po nes
Sa la
ud Ru nd
i A ss
So Sl rabi a
ut ov i a
h a
S r A fr ki a
i L ica
Ta a nk
Th iw a
a i an
T la
Average Skewness in Emerging Markets
V ur nd
e
Zi nez ke y
Comba uela
m bw
po e
sit
e
29
A
us
t
-1
0
1
2
3
4
5
6
A ralia
us
Be tri

l a
Ca gium
D na
en da
m
Fi ark
n
Fr land
G an
H erm ce
on a
g ny
K
Ire ong
la
n
Ita d
N J ly
N ethe apa
ew rl n
Ze and
a s
N l and
o
Po rwa
rtu y
g
Campbell R. Harvey
Sp al
Sw Sw ain
it z ede
er n
la
nd
U
K
W U
or W S
ld or
ex ld
-
EAUS
FE
Average Excess Kurtosis in Developed Markets
30
A
rg
e
0
1
2
3
4
5
6
-1
Banti n
hr a
Br a in
a
Chz il

Cz C C il
e c o hi e
h lom na
Re b
pu ia
Egbl ic
G yp
H ree t
un c e
ga
In In ry
do di
ne a
Is sia
Jo rael
rd
M Ko an
ala re
a
M ysi a
M ex
or ic
o o
N cco
ig
er
Pa Om i a
ki an
Ph sta n
ili Pe
pp ru
i
Campbell R. Harvey
Po nes
Sa R lan
ud u d
i A ssi
So Sl rab a
ut ov i a
h a
Sr Afr ki a
i L ica
Ta a nk
Th iw a
a i an
T la
V ur nd
e k
Zi nez e y
Comba uela
m bw
po e
sit
Average Excess Kurtosis in Emerging Markets
e
31
8. Factors
Related to simple CAPM: Rit – rft = ai + bi[Rmt – rft] + eit
1. SR (systematic risk) is the beta, bi in the

simple CAPM equation
2. TR (total risk) is the standard deviation of
country return si
3. IR (idiosyncratic risk) is the standard
deviation of the residual in simple CAPM, eit
8. Factors
Related to size
4. Log market capitalization
8. Factors
Related to semi-standard deviation:
Semi-B =, (1 / T )  Tt1 ( Rt  B) 2 for all Rt < B
5. Semi-Mean is the semi-standard deviation

with B = average returns for the market
6. Semi-rf is the semi-standard deviation with B
= U.S. risk free rate
7. Semi-0 is the semi-standard deviation with B
=0
8. Factors
Related to downside beta
8. Down-biw is the b coefficient from market

model using observations when country
returns and world returns are simultaneously
negative.
9. Down-bw is the b coefficient from market
model using observations when world returns
negative.
8. Factors
Related to value at risk
10. VaR is a value at risk measure. It is the

simple average of returns below the 5th
percentile level.
8. Factors
Related to skewness
11. Skew is the unconditional skewness of returns.

It is calculated by taking the
Mean(ei3)
{Standard deviation of (ei)}^3
12. Skew5%:
{(return at the 95th percentile – mean return) -
(return at 5th percentile level – mean return)} - 1
8. Factors
Related to coskewness
13. Coskew1 is:

(S ei * em2)/T
{square root of (S(ei2 )/T)) } * {(S em2)/T)}
14. Coskew2 is:

(S ei * em2)/T
{standard deviation of (em)}^3
8. Factors
Related to spread
15. Kurt is the kurtosis of the return distribution
8. Factors
Related to political risk
16. ICRGC is the log of the average monthly

International Country Risk Guide’s (ICRG)
country risk composite
17. CCR is the log of the average semi-annual
country risk rating published by Institutional
Investor.
18. ICRGP is the log of the average monthly ICRG
political risk ratings.
8. Factors
Related to Fama-French 3-factor model
19. betahml - HML

20. betasmb - SMB
8. Factors
Related to commodity prices and inflation
21. betaoil - Oil Price (Change in Brent index)

22. binfl - Weighted average of G7 inflation using
GDP deflator.
8. Factors
Related to FX risk
23. betafx - The trade weighted FX to $ given by

the Federal Reserve
24. betafx1- Simple average $ -Euro and $-Yen
8. Factors
Related to Interest Rates
25. bintr - Real interest rate - Weighted average

short-term interest rate/Weighted average of
inflation
26. bterm - Weighted average difference between
long and short rates
8. Factors
Related to Economic Activity
27. betaip - OECD G7 industrial production
9. Results
5
y = -0.8121x + 0.8964
2 4
R = 0.118
3
Mean Returns
2
1
0
-1.50 -1.00 -0.50 -10.00 0.50
Coskew2
9. Results
5
y = 0.1586x + 0.3226
4 2
R = 0.1673
3
Mean Returns
2
1
0
-10.00 5.00 10.00 15.00 20.00
Kurtosis
9. Results
Multiple Regressions - All Markets
Risk1 / Risk2 c0 p-value c1 p-value c2 p-value R2
SR / TR -0.3051 0.2370 0.4638 0.0540 0.1054 0.0000 0.470
SR / IR -0.2491 0.3280 0.6110 0.0080 0.0944 0.0000 0.459
SR / Size 0.3817 0.2400 0.9780 0.0000 -0.0451 0.5150 0.278
SR / Semi - Mean -0.2923 0.2900 0.4350 0.0970 0.1610 0.0010 0.427
SR / Semi - rf -0.1101 0.7130 0.6483 0.0200 0.1114 0.0460 0.335
SR / Semi-0 -0.0878 0.7640 0.6460 0.0210 0.1119 0.0450 0.335
SR / Down-biw 0.0555 0.8360 0.6375 0.0320 0.4776 0.0840 0.320
SR / Down-bw 0.1791 0.4770 0.5493 0.1210 0.3252 0.1300 0.309
SR / VAR -0.0937 0.7440 0.5945 0.0360 -0.0371 0.0320 0.344
SR / skew 0.0580 0.8020 0.8795 0.0000 0.5256 0.0010 0.427
SR / skew5% 0.0881 0.7430 1.0000 0.0000 1.0737 0.1310 0.308
SR / coskew1 0.0873 0.7460 0.9747 0.0000 -1.0720 0.1380 0.307
SR / coskew2 -0.0099 0.9680 0.9638 0.0000 -0.8360 0.0040 0.396
SR / kurt -0.3296 0.2950 0.8553 0.0000 0.1302 0.0080 0.381
SR / ICRGC 7.5150 0.0640 0.9550 0.0000 -1.6895 0.0720 0.323
SR / CCR 2.6242 0.0270 0.9561 0.0000 -0.5971 0.0400 0.339
SR / ICRGP 2.5330 0.4660 0.9618 0.0000 -0.5372 0.5100 0.278
9. Results
• Harvey and Siddique (2000, Journal of

Finance) “Conditional Skewness in Asset
Pricing Tests” find that skewness is able to
explain one of the most puzzling anomalies in
asset pricing: momentum
9. Results
25
12-month momentum
20
15
Mean
10 y = -5.3067x + 24.869
R2 = 0.5934
5
0
0 0.5 1 1.5 2 2.5 3
Skew
10. Conditional Skewness
• Bakshi, Harvey and Siddique (2002) examine

the fundamental determinants of volatility,
covariance, skewness and coskewness
For 1996
f 5skew
7. 00
5. 44
3. 89
2. 33
0. 78
- 0. 78
- 2. 33
- 3. 89
- 5. 44
- 7. 00
- 0. 55
0. 31
1. 16
2. 02
2. 88
3. 73
4. 59 0. 000
0. 053
5. 45 0. 106
0. 158
l ogsi ze 6. 31 0. 211
7. 16 0. 264
0. 317
8. 02 0. 370
0. 422book_m kt
8. 88 0. 475
0. 528
9. 74 0. 581
10. 59 0. 634
0. 686
11. 45 0. 739
• Skewness can be especially important in

hedge fund strategies where derivatives play
an explicit role in trading strategies
Co-Skewness Measure (Definition 2)

(Total of 42 Funds, over Jan 1997 - Feb 2001)
4
3.5
Mean Returns (Geometric)
3
2.5
2
1.5
1
0.5
0
-0.4 -0.3 -0.2 -0.1 -0.5 0 0.1 0.2 0.3
Coskew ness
Source: Lu and Mulvey (2001)

Co-Skewness Measure (Definition 2)

(Total of 42 Funds, over Jan 1997 - Feb 2001)
4
3.5
Mean Returns (Arithmetic)
3
2.5
2
1.5
1
0.5
0
-0.4 -0.3 -0.2 -0.1 -0.5 0 0.1 0.2 0.3
Coskew ness
Source: Lu and Mulvey (2001)

11. Three-Dimensional Analysis
12. Estimation Error
• Goal is the maximize expected utility (find the

point on the frontier that best matches our
utility)
• However, all the moments are estimated with
error
• Traditional analysis does not take this
estimation error into account
• Small movements along the frontier can cause

radical swings in weights
• Popular “solutions” involve the resampling of the

efficient frontier
• Basically, the step are:
– (1) Calculate the means, variances and covariances
– (2) Simulate data based on (1)
– (3) Solve for efficient weights
– (4) Repeat (2) and (3) many times
– (5) Average the weights for each asset to get the “resampled”
frontier, call it w*
• However, the average of a set of maximums is

not the maximum of an average
• The expected utility for w* will be less than the
maximum expected utility
• Hence, current techniques are suboptimal
• Harvey, Liechty, Liechty and Müller (2002)

“Portfolio Selection with Higher Moments”
provide an alternative approach
– (1) Generate samples of parameters (means, etc)
using a Bayesian estimation procedure
– (2) Estimate expected utility
– (3) Find weights that maximize expected utility
• Harvey, Liechty, Liechty and Müller (2002)

“Portfolio Selection with Higher Moments”
provide an alternative approach
– (4) For two moments, use Normal distribution
– (5) For three moments, use Skew Normal
distribution
Results Using Multivariate Normal
Max Expected Expected Utility Expected Utility

 Utility using using Max Utility using Michaud
Normal weights from and Normal
Normal
0.00 0.154 0.154 0.150
0.03 0.009 0.009 0.008
0.06 -0.125 -0.125 -0.128
utility =  – *s
2
Results Using Multivariate Skewed Normal
Max Expected Expected Utility Expected Utility Expected Utility
  Utility using using Michaud using Max using Michaud
Skewed Normal and Skewed Utility weights weights from
Normal from Normal Normal
0.00 0.01 0.122 0.119 0.122 0.109
0.00 0.50 0.106 0.103 0.074 0.050
0.03 0.01 0.003 0.002 0.000 -0.004
0.03 0.50 0.004 -0.007 -0.001 -0.006
0.06 0.01 -0.132 -0.134 -0.135 -0.141
0.06 0.50 -0.132 -0.138 -0.136 -0.143
utility =  – *s + * I{ >0} + 2** I{ < 0}

2
 is skewness and I{ } is an indicator function, I{ < 0} = 1, if  < 0 and 0, if  >= 0.
13. Conclusions
• Both conditioning information and higher

moments matter
• People make portfolio choices based on
“predictive” distributions – not necessarily
what has happened in the past
• Investors have clear preference over skewness
which needs to be incorporated into our
portfolio selection methods
Readings
• “Distributional Characteristics of Emerging Market Returns and Asset Allocation,"

with Geert Bekaert, Claude B. Erb and Tadas E. Viskanta, Journal of Portfolio
Management (1998), Winter,102-116.
• “Autoregressive Conditional Skewness,” with Akhtar Siddique, Journal of
Financial and Quantitative Analysis 34, 4, 1999, 465-488.
• “Conditional Skewness in Asset Pricing Tests,” with Akhtar Siddique, Journal of
Finance 55, June 2000, 1263-1295.
• “Time-Varying Conditional Skewness and the Market Risk Premium,” with Akhtar
Siddique, Research in Banking and Finance 2000, 1, 27-60.
• “The Drivers of Expected Returns in International Markets,” Emerging Markets
Quarterly 2000, 32-49.
• “Portfolio Selection with Higher Moments,” with John Liechty, Merrill Liechty,
and Peter Müller, Working paper.
• “Fundamental Risk,” with Gurdip Bakshi and Akhtar Siddique, Working paper.
• Nan Q. Lu and John M. Mulvey, “Analyses of Market Neutral Hedge Fund
Returns” ORFE-01-1, Princeton University

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Inquire UK

• The asset allocation setting

• Types of asset allocation

• Conditioning information makes a

Data through June 2002

• Adding conditioning information is like

Traditional fixed weight

• Traditional models maximize expected

• Much interest in downside risk, asymmetric

• ... These are just terms that describe the

1. The $1 lottery ticket. The expected value is

2. High implied vol in out of the money OEX

2. High implied vol in out of the money S&P index

3. Some stocks that trade with seemingly

3. Some stocks that trade with seemingly

• CAPM with skewness invented in 1973 and

• Covariance is the contribution of the

Data through June 2002

Data through June 2002

Data through June 2002

Data through June 2002

1. SR (systematic risk) is the beta, bi in the

4. Log market capitalization

5. Semi-Mean is the semi-standard deviation

8. Down-biw is the b coefficient from market

10. VaR is a value at risk measure. It is the

11. Skew is the unconditional skewness of returns.

13. Coskew1 is:

14. Coskew2 is:

15. Kurt is the kurtosis of the return distribution

16. ICRGC is the log of the average monthly

19. betahml - HML

21. betaoil - Oil Price (Change in Brent index)

23. betafx - The trade weighted FX to $ given by

25. bintr - Real interest rate - Weighted average

27. betaip - OECD G7 industrial production

• Harvey and Siddique (2000, Journal of

• Bakshi, Harvey and Siddique (2002) examine

• Skewness can be especially important in

Co-Skewness Measure (Definition 2)

Source: Lu and Mulvey (2001)

Co-Skewness Measure (Definition 2)

Source: Lu and Mulvey (2001)

• Goal is the maximize expected utility (find the

• Small movements along the frontier can cause

• Popular “solutions” involve the resampling of the

• However, the average of a set of maximums is

• Harvey, Liechty, Liechty and Müller (2002)

• Harvey, Liechty, Liechty and Müller (2002)

Results Using Multivariate Normal

Max Expected Expected Utility Expected Utility

utility =  – *s + * I{ >0} + 2** I{ < 0}

 is skewness and I{ } is an indicator function, I{ < 0} = 1, if  < 0 and 0, if  >= 0.

• Both conditioning information and higher

• “Distributional Characteristics of Emerging Market Returns and Asset Allocation,"

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utility =  – s +  I{ >0} + 2 I{ < 0}