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UC Berkeley

Title:

Fragility of CVaR in portfolio optimization

Author:

Lim, A.E.B., UC Berkeley

Shanthikumar, J.G., Purdue University

Vahn, G.-Y., UC Berkeley

Publication Date:

09-21-2009

Series:

Coleman Fung Risk Management Research Center Working Papers 2006-2013

Permalink:

http://escholarship.org/uc/item/5pp7z1z8

Keywords:

portfolio optimization, conditional value-at-risk, expected shortfall, TailVaR, coherent measures

of risk, mean-CVaR optimization, mean-variance op- timization, global minimum CVaR, global

minimum variance, estimation errors

Abstract:

Abstract We evaluate conditional value-at-risk (CVaR) as a risk measure in data-driven portfolio

optimization. We show that portfolios obtained by solving mean-CVaR and global minimum CVaR

problems are unreliable due to estimation errors of CVaR and/or the mean, which are aggravated

by optimization. This prob- lem is exacerbated when the tail of the return distribution is made

heavier. We conclude that CVaR, a coherent risk measure, is fragile in portfolio optimization due

to estimation errors.

Copyright Information:

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services to the University of California and delivers a dynamic

research platform to scholars worldwide.

Fragility of CVar

in portfolio optimization

J.G. Shanthikumar, Purdue University

G.-Y. Vahn, UC Berkeley

September 21,2007

University of California

Berkeley

A.E.B. Lim

J.G. Shanthikumar

G.-Y. Vahn

Abstract

mean-CVaR and global minimum CVaR problems are unreliable due to estimation

errors of CVaR and/or the mean, which are aggravated by optimization. This problem is exacerbated when the tail of the return distribution is made heavier.

conclude that CVaR, a

coherent

We

to estimation errors.

Keywords:

TailVaR, coherent measures of risk, mean-CVaR optimization, mean-variance optimization, global minimum CVaR, global minimum variance, estimation errors

Berkeley, CA 94720.

Corresponding Author. Department of Industrial of Engineering & Operations Research, University of California, Berkeley, CA 94720. E-mail: gyvahn@berkeley.edu.

The authors are grateful to A. Jain for comments and suggestions, and to the Coleman Fung Risk

Management Research Center for nancial support.

Introduction

Conditional value-at-risk

CVaR at level

100(1 )%,

and is

refers to the threshold level for losses in the top

100(1 )%.

2

of VaR is partly blamed for the 2007-2008 nancial crisis , CVaR is more appealing

than VaR because it takes into account the contribution from the very rare but very

large losses. Formally, CVaR is a coherent risk measure, in that it satises [Pug

(2000), Acerbi and Tasche (2001)] the four coherence axioms

There have been many studies on CVaR once its coherence was established. In

statistics/econometrics, there have been studies about CVaR estimation [Scaillet

(2004), Brown (2007) and Chen (2008), to name a few]. Another line of work has

been in incorporating CVaR as a risk measure in portfolio optimization, led by

Rockafellar and Uryasev (2000) and Krokhmal, Palmquist and Uryasev (2002) [and

independently Bertsimas, Lauprete and Samarov (2004)], who developed numerical

methods for computing optimal portfolios with CVaR in the objective or in the

constraint.

If the underlying return distribution is multivariate normal and the investor knows

its parameters, then the portfolio that minimizes CVaR with an expected return

is equivalent to the portfolio that minimizes variance (or VaR) with the same

expected return

et al. (2004)].

portfolios coincide if plotted on the same scale. The same authors also consider the

case where the investor does not know the model and computes optimal portfolios

purely based on historical data.

that the

empirical frontiers 4

similar for the (dierent) assets and time periods under consideration. This merely

indicates that the data used were approximately multivar! iate normal, and deems

1 Also

the New York Times article Risk Mismanagement (Jan. 2, 2009) by Joe Nocera, for an

account of the use of VaR as a risk measure in the nancial industry.

3 Translation invariance, subadditivity, positive homogeneity and monotonicity. VaR violates

subadditivity [Artzner, Delbaen, Eber and Heath (1999), Embrechts, Resnick and Samorodnitsky

(1999)], i.e. diversication can result in greater risk.

4 See Sec. (2) for a precise denition.

2 See

Nevertheless,

the proponents of CVaR argue that its usefulness will be evident when the return

distributions deviate from normality; in particular when they have fat left tails, as

is often the case in `crisis' periods [Litzenberger and Modest (2008)]. However, to

date, no studies on the use of CVaR as a risk measure in such a market have been

done to validate this claim.

One important point that has been omitted by Artzner et al. (and subsequent

works on CVaR) is the role of estimation errors in the computation of a risk measure,

and their eect on decision-making, such as portfolio optimization. CVaR may be

coherent, but a large number of observations are needed to estimate it accurately

because it is a tail statistic. However, in nancial risk management, historical data

older than 5 years are rarely used because underlying distributions are non-stationary

over a long period of time. Thus from a practical perspective, data-driven portfolio

optimization that involves estimated statistics is subject to estimation errors that

may be very signicant. Such observations in the context of mean-variance optimization have been made by Jorion (1985), Michaud (1989), Broadie (1993) and Chopra

and Ziemba (1993), where the quality of the solution was shown to be greatly aected

by estimati! on errors of the mean. We believe that an understanding of the impact

of estimation errors in CVaR (as well as other tail risk measures) is important given

its increasing popularity.

The goal of this paper is thus to provide an objective analysis of the use of CVaR

as a risk measure in data-driven portfolio optimization. Specically, we set out to

answer the following questions:

How do estimation errors aect data-driven portfolio optimization that minimize CVaR as an objective?

optimization in a heavy-tailed market?

To address these questions, we look at the mean-CVaR frontiers associated with the

solution of empirical mean-CVaR problems constructed from data generated under

dierent market models. We will rst show that these empirical mean-CVaR frontiers

vary wildly when both mean and CVaR are empirically estimated (call this problem

EMEC, for

To isolate the

eect of the mean, we also consider (i) global minimum CVaR portfolio optimization

(GMC) and (ii) mean-CVaR problem where the true mean is known (TMEC for

5 Of

3

mean-empirical variance (EMEV), global minimum variance (GMV) and true meanempirical variance (TMEV) problems.

To see the eect of the tail behavior of return distributions, we do the analysis

mentioned above for three dierent market scenarios: excess return distributions are

multivariate normal ( 1), mixture of multivariate normal and negative exponential

tail (2), or mixture of multivariate normal and one-sided power tail ( 3). Such

mixture distributions represent a normal market that undergoes a shock with a small

probability, with increasing heaviness in the tail.

The details of the evaluation methodology can be found in Sec. (2), of the optimization problems in Sec. (3) and simulation results and discussion in Sec. (4).

Evaluation Methodology

risky assets. We

X = [1 , . . . , ] .

the excess returns of the assets by the random vector

denote

To see

how estimation errors aect EMEC portfolio optimization, we employ the following

procedure :

1. Choose

could be a multivariate normal distribution

with parameters

(, V).

D = [x1 . . . , x ]

under

3. Fix a portfolio return level

problem (see Sec. (3) for details on the optimization). For the same data set

D,

is random.

compute its expected (excess) return and CVaR under the true model

plot the resulting mean-CVaR values.

frontier,

and

empirical

6 We

employ a similar procedure for TMEC/TMEV and GMC/GMV portfolio optimization; the

only dierence is in the optimization problem we solve in Step 3.

4

true performance of the EMEC portfolios. Note the empirical frontier is also

random.

5. Repeat Steps 3-4 for EMEV( ; D, ) portfolio optimization.

6. Repeat Steps 2-5 many times (50 in our study), each time with fresh input

data

D.

frontiers.

To see the eect of the tail of return distributions, we consider market models

with increasingly heavier one-sided tail; the exact characterizations of these markets

are in Sec. (4.2). Next, we provide details of the optimization.

3.1

quadratic program:

min ()

(1a)

..

= 1

(1b)

=1

g ,

where

(1c)

()

is the sample covariance matrix computed from the observed data. For

1

the EMEV problem, g =

=1 x , i.e. the sample mean, and for the TMEV

problem, g = (X). For the GMV problem, we omit the constraint (1c).

3.2

is given by solving:

1

min +

( x )+

,

(1 ) =1

..

= 1

(2a)

(2b)

=1

g ,

5

(2c)

where

D = [x1 , . . . , x ]

afellar and Uryasev (2000) that (2) can be transformed into a linear program. Again,

1

for the EMEC problem, g =

=1 x , and for the TMEC problem, g = (X),

and for the GMC problem, we omit the constraint (2c).

(Rockafellar and Uryasev (2000) ). Let X be a vector of iid asset

returns, with a continuous cdf and a density function . Then CVaR at level of a

portfolio can be expressed as an optimization problem:

Theorem

1

CVaR(; ) = min +

( x)+ (x)x.

xR

4.1

Returns

4.1.1

multivariate normal

Model Description

normal distribution:

X (, )

where

(1)

3.730, 3.908, 4.943,

=

4.420, 4.943, 8.885,

3.606, 3.732, 4.378,

3.673, 3.916, 5.010,

3.606,

3.732,

4.378,

3.930,

3.799,

7 For

3.673

3.916

5.010

3.789

4.027

104 ,

104 .

a xed portfolio , the sample estimate (2a) is a non-parametric estimator for the portfolio's CVaR. It can be shown that this estimator is related to another popular non-parametric

estimator of CVaR, and both are weakly consistent and asymptotically normal with data size .

Note, however, that this does not say that the empirical CVaR of the optimized portfolio is asymptotically normal. See Lim, Shanthikumar and Vahn (n.d.) for details.

8 The vector and the matrix are the sample mean and covariance matrix of 299 monthly

excess returns of 5 stock indicies (NYA, GSPC, IXIC,DJI,OEX) from the period spanning August

3, 1984 to June 1, 2009.

6

4.1.2

the returns for these portfolios under model

We then simulate

and true CVaR, and generate the empirical frontiers in Fig. (1). Note we could have

equally chosen true variance as the common risk scale. We also emphasize that the

frontiers are not observed by the investor herself; they show the variability in the

performance of empirical portfolio optimization under the true model.

The frontiers of empirical mean-empirical CVaR (red) and empirical meanempirical variance (blue) portfolios under model 1. All scales are bps/mth.

Figure 1:

= 50 ( 4

CVaR = 1000 bps/mth

The EMEC and EMEV frontiers both vary wildly; for example, with

years), the range of expected excess return of a portfolio with

per dollar invested

12

a relative excess return ratio greater than (1.0072

1)/(1.002512 1) 300%

per year.

that the positions and the spread of the frontiers are very similar.

This is not

very surprising, since, as previously mentioned, theoretical mean-variance and meanCVaR problems yield equivalent solutions if the underlying asset returns have a

multivariate normal distribution. Thus in a normal market, the EMEC problem is

subject to large estimation errors of the mean, as is the EMEV problem. The same

shortcomings apply to markets with heavier tails, as estimating the mean becomes

more dicult as the underlyi! ng distribution becomes more irregular.

9 We

7

errors of the mean. What if we remove the expected return constraint, or assume

the investor knows the true mean of asset returns? Removing the expected return

constraint is a natural extension of EMEC and EMEV problems

10

, and allows us

to compare errors of CVaR and variance without errors of the mean. On the other

hand, assuming the investor knows the true mean is an idealization of the situation

where the investor has a good estimate of the mean obtained from alternatives to

the sample average, e.g. based on CAPM [Huang and Litzenberger (1988)], forecasts

of exceptional returns [Grinold and Kahn (2000)], factor models [Fama and French

(1993)], or incorporating investor knowledge via Black-Litterman [Black and Litterman (1991)]. In this regard, the TMEC model will allow us to evaluate whether the

hard work put into estimating the mean can be destroyed by the errors associated

with estimating CVaR. Hence, for the rest of the paper, we consider (i) GMC/GMV

and (ii) TMEC/TMEV problems.

4.1.3

We plot expected return vs. true CVaR of portfolios that solve the GMC problem

(red) for

in Fig. 4(a).

plotted (blue). In Table 1, we give the ranges for CVaR and expected return values

corresponding to the solutions of GMC/GMV problems from our 50 simulations. We

observe that GMV portfolios outperform GMC portfolios in that most blue stars are

found on the left of the red stars (i.e. more accurate) and also are less spread out (i.e.

more precise). The GMC portfolios are not precise at all; e.g. for our 50 simulations,

when

= 50,

What are the origins of the variation in the GMC empirical frontiers? In order

to distinguish between the eects of inherent estimation errors and the optimiza-

against True CVaR. By Perceived CVaR we mean the optimal objective from solving

the GMC problem, i.e. the CVaR value perceived by the investor. By Random Empirical CVaR we mean the empirical CVaR 11 of portfolios that are randomly drawn 12

from the set of portfolios that satisfy the constraint (2b). True CVaR refers to the

tion procedure, we plot in Fig. 3(a)

true CVaR value of a portfolio. Thus the scatter plot of Random Empirical CVaR

10 The

GMV problem is currently being studied as an alternative to the EMEV problem [see

Jagannathan and Ma (2003), DeMiguel, Garlappi, Nogales and Uppal (2009)].

11 Dened by (2a).

12 Note the drawing procedure was not uniform.

8

against True CVaR (blue) gives an indication of the inherent estimation errors

before

optimization, and the scatter plot of Perceived CVaR against True CVaR (re! d) gives

an indication of how the optimization aects the already present estimation errors.

We observe that empirical CVaR values of randomly drawn, unoptimized portfolios

are slightly biased in the direction of underestimating the true CVaR

13

. However,

the position of the red dots they are generally further below the black line (perfect

estimation) than the blue dots. In Table 1, we highlight this phenomenon by listing

the ranges of Perceived CVaR as well as the true CVaR for the GMC problem.

4.1.4

ical frontiers (red) for dierent data sizes

= 0.99) empir-

the blue curves). In Table 2, we give the ranges for CVaR and expected return values

corresponding to the solutions of TMEC/TMEV problems from our 50 simulations.

In all three instances, the spreads of the TMEV empirical frontiers are signicantly

smaller than the TMEC empirical frontiers, and the TMEV empirical frontiers lie

on the left-most side of the TMEC curves, closer to the theoretical frontier. Thus a

portfolio manager who wishes to nd the optimal TMEC portfolio should solve the

TMEV problem to get a portfolio with higher accuracy and precision. For example,

CVaR = 1000 bps/mth and = 50 using TMEV optimiza56.6 bps/mth, but a manager with the

same risk level using TMEC optimization generates 52.3 bps/mth 8.5% per year

higher excess return, on average. Furthermore, the TMEV manager is more reliable;

e.g. for our 50 simulations and

= 50,

whereas for the TMEC manager it is 621942 bps/mth for the same expected return

of

40

bps/mth.

As with the GMC problem, the variation in the TMEC portfolios is due to inherent estimation errors of CVaR coupled with the eect of optimization. In Fig. 3(b)

we plot the Perceived CVaR of GMC portfolios in red, and empirical CVaR of random portfolios that satisfy (2b) in blue; notice the red dots are generally further

below the black line (perfect estimation) than the blue dots. This is further veried

by the CVaR (per) column in Table 2. This tells us that the TMEC investor can

substantially underestimate the true CVaR value of her `optimal' portfolio and be

13 This

is because the sample estimator from (2a) is biased in the direction of underestimation

[Lim et al. (n.d.)].

9

Lastly, we comment on the dierence between the performance of TMEC and

TMEV empirical frontiers.

pirical frontiers coincide; thus the discrepancy in the observed performance suggests

that estimation errors of CVaR are more signicant than of variance.

This is not

surprising since the mean vector and the covariance matrix are minimal sucient

statistics of a multivariate normal model. Thus minimizing portfolio variance only

contains errors of the covariance matrix, which are less signicant than errors of the

mean, whereas minimizing portfolio CVaR contains errors of both the mean vector

and the covariance matrix.

4.2

Returns

multivariate normal

Recall that one of our objective is to evaluate CVaR portfolio optimization in markets with heavier tails. We now present analysis of GMC/GMV and TMEC/TMEV

problems for two such markets.

4.2.1

negative exponential distributions, such that with a small probability, all assets suer

a perfectly correlated exponential-tail loss. Formally,

X (1 ()) (, V) + ()( e + f ),

(2)

f = [1 , . . . , ] is a 1 vector of constants, and Y is a negative exponential

where

and

{

,

( = ) =

0

In our simulations, we consider

and

= 10.

= 0.05

(i.e.

if 0

otherwise.

one shock every

10, 000

1.7 years),

sample returns of

is shown in

Fig. (2b).

4.2.2

one-sided power distribution, such that with a small probability, all assets suer a

10

X (1 ()) (, V) + ()()f ,

where

()

, f = [1 , . . . , ] is a

dened for 1 such that

() is a random variable

{

( 1)()

if 1

(() = ) =

0

otherwise.

X under 3 has

nite variance

= 0.05, = 5 , and = 3.5.

1 is shown in Fig.(2c).

Note

4.3

4.3.1

(3)

for

> 3.

10, 000

sample returns of

Discussion of results

Global minimum CVaR (GMC) problem

The expected return vs. true CVaR of GMC and GMV portfolios under models

return values corresponding to the solutions of GMC and GMV problems from our

50 simulations.

In

and

2,

portfolios in that the blue stars are further to the left (i.e. more accurate) and have

substantially smaller vertical and horizontal spreads (i.e. more precise) than the red

stars. In

3,

the GMV portfolios are slightly more accurate and precise than GMC

= 50, but the GMC portfolios converge faster with increasing data

as nancial data older than 5 years is rarely used in practice, = 50

portfolios when

size. However,

presents the most realistic scenario, and in this case, the GMV problem is clearly

more reliable than the GMC problem across all models. In addition, when

= 50,

t!

True CVaR range is 273610610 bps/mth, whereas Perceived CVaR range is 1053

4957 bps/mth for the same expected return

4.3.2

40

bps/mth.

13

are

plotted in Fig. (5). In Table 2, we give the ranges for CVaR and expected return

values corresponding to the solutions of TMEC/TMEV problems from our 50 simulations. For comparison, we also provide the ranges for EMEC/EMEV problems under

1.

Across all models, the TMEV empirical frontiers perform better than TMEV

11

empirical frontiers in that the blue curves are further to the left and have smaller

spreads than the red curves. There are dierences between the models, however

the TMEV most out-perform TMEC portfolios in

performance of TMEV empirical frontiers at

However, as previously mentioned,

= 50

2,

whereas in

3,

the out-

in this case, the TMEV problem is clearly more reliable than the TMEC problem

across all models.

The inve!

= 50

for our

range is 461916 bps/mth for the same expected return

40

bps/mth.

We can also see the eect of assuming the investor knows the true mean from

the

columns in Table 2 and comparing Fig. (1) and Fig. (5(a)), we see that

substantially when the true mean is known. However, even if the investor estimates

the mean exactly, estimation errors in CVaR can signicantly aect the reliability of

empirical frontiers, as is the case for

2.

Conclusion

In this paper, we have empirically evaluated CVaR as a risk measure in data-

driven portfolio optimization. We have focused on two goals: to see the eects of

estimation errors on portfolio optimization that minimize CVaR as an objective,

and to determine whether such optimization is reliable in heavy-tailed markets. We

summarize our ndings below.

problem, just as the empirical mean-empirical variance problem. As the difculty in estimating the mean is well-known, we focused on global minimum

CVaR/variance and true mean-empirical CVaR/variance problems for the rest

of the paper.

The portfolio solutions of GMC and TMEC problems are unreliable due to

statistical errors associated with estimating CVaR coupled with the eect of

optimization, which tends to amplify the statistical errors.

An investor who

minimizes CVaR is thus likely to nd a portfolio that is far from being ecient with substantially underestimated CVaR; her risk exposure is likely to be

substantially higher than she might otherwise realize.

The analysis of the TMEC problem show that any benets of accurately estimating expected return are destroyed by estimation errors of CVaR.

12

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Appendix

Figure 2: Histogram for 10,000 samples of 1 (bps/mth) under model (a) 1, (b) 2

and (c) 3.

15

(a)

(b)

Random Empirical CVaR vs. True CVaR (blue) and Perceived CVaR vs. True

CVaR (red) for (a) true mean-empirical CVaR problem and (b) global minimum CVaR

problem under model 1. All scales are bps/mth.

Figure 3:

16

(a)

(b)

(c)

The empirical frontiers of global minimum variance (blue) and global minimum

CVaR (red) portfolios under models (a) 1 (b) 2 and (c) 3. All scales are bps/mth.

Figure 4:

17

(a)

(b)

(c)

18

The empirical frontiers of true mean-empirical variance (blue) and true meanempirical CVaR (red) portfolios under models (a) 1 (b) 2 and (c) 3. In (a), we also

plot the theoretical mean-variance (equivalently, mean-CVaR) frontier in green (found at

the left-most edge of the blue curves). All scales are bps/mth.

Figure 5:

19

= 400

= 200

= 50

Exp. Return

= 400

= 200

= 50

CVaR

GMC (true)

465723

(257)

466657

(191)

464562

(98)

9.1543.2

(34.1)

10.134.6

(24.5)

17.833.5

(15.7)

GMV

465560

(96)

463481

(18)

463472

(9)

16.531.7

(15.2)

20.927.5

(6.67)

22.425.9

(3.55)

-14.984.7

(99.6)

-11.437.8

(49.2)

8.3141.5

(33.2)

165380

(257)

314494

(180)

377497

(121)

GMC (per)

-42.4 -25.8

(16.6)

-36.9 -31.6

(5.30)

-36.9 -32.5

(4.40)

22982391

(93)

23322374

(42)

23392376

(37)

GMV

-90.027.0

(117)

-70.9 -1.43

(69.5)

-73.6 -9.21

(64.4)

220411120

(8916)

22024258

(2056)

21942876

(682)

GMC (true)

-318426

(744)

-34.498.5

(132.8)

-52.98.03

(61.0)

1884706

(4518)

10204738

(3718)

12403439

(2199)

GMC (per)

-45.89.63

(55.4)

-28.810.2

(39.0)

-21.87.94

(29.8)

9902151

(1161)

9741764

(792)

9801580

(600)

GMV

-66.319.6

(85.9)

-18.9 17.3

(36.3)

-9.3014.9

(24.2)

10432758

(1715)

10071403

(396)

9881177

(189)

GMC (true)

-183 48.1

(232)

-19.7 -34.8

(54.6)

-20.4 -5.65

(14.8)

255687

(432)

480837

(357)

555946

(391)

GMC (per)

Expected return and CVaR (true and perceived) ranges (bps/mth) for 50 GMC and GMV portfolios. In

parenthesis is the size of the range.

Table 1:

20

= 400

= 200

= 50

60bps/mth

= 400

= 200

= 50

Exp. Return

40bps/mth

4702650

(2180)

5204440

(3920)

5602300

(1740)

4602720

(2260)

4804220

(3740)

5502280

(1730)

TMEC

4902150

(1660)

4903120

(2630)

4701250

(780)

4702210

(1740)

4602970

(2510)

4701200

(730)

TMEV

EMEV/EMEC

10391179

(140)

10381063

(25)

10381055

(17)

613691

(78)

612624

(12)

612620

(8)

TMEV

10561747

(691)

10421294

(252)

10451183

(138)

621942

(321)

624910

(286)

612709

(97)

TMEC (true)

220963

(742)

6921182

(490)

7981186

(388)

171588

(417)

426697

(271)

484692

(208)

TMEC (per)

31393542

(403)

31403213

(73)

31393175

(36)

27212992

(271)

27202772

(52)

27202745

(25)

TMEV

TMEV/TMEC

316110570

(7409)

31554538

(1383)

31483555

(406)

273610610

(7874)

27394423

(1684)

27283388

(660)

TMEC (true)

12825031

(3750)

20025126

(3124)

23934122

(1729)

10534957

(3903)

17594998

(3239)

19043940

(2036)

TMEC (per)

12871530

(243)

12861740

(455)

12861450

(164)

11101242

(132)

11091291

(182)

11101179

(69)

TMEV

12942072

(779)

12881719

(431)

12871454

(167)

11231778

(655)

11131518

(405)

11121299

(187)

TMEC (true)

5651100

(536)

8141362

(549)

10081492

(484)

469916

(447)

6861159

(472)

8461288

(443)

TMEC (per)

CVaR (true and perceived) ranges (bps/mth) for 50 mean-risk empirical frontiers at xed expected return

levels. In parenthesis is the size of the range.

Table 2:

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