Applied Economics, 1991, 23, 465-470 Optimal algorithms and lower partial moment: ex post results DAVID N, NAWROCKI College of Commerce and Finance, Villanova University, Villanova, PA 19085 Portfolio management in the finance literature has typically used optimization algorithms to determine security allocations within a portfolio in order to obtain the best trade-off between risk and return. These algorithms, despite some improvements, are restrictive in terms of an investor's risk aversion (utility function). Since individual investors have different levels of risk aversion, this paper proposes two portfolio- ‘optimization algorithms that can be tailored to the specific level of risk aversion of the individual investor and performs ex post evaluation tests of the algorithm performance, 1, INTRODUCTION Optimization algorithms in portfolio management cither require restrictive investor utility functions or the utility analysis is eliminated in a CAPM or APT equilibrium environment. While the utility-free methodology is useful, it is based on the separation theorem and, therefore, on an cavironment with zero transactions costs and unlimited borrowing. Since financial markets are characterized by ‘both transaction costs and limited borrowing (margin re- quirements}, a utilty-dependent approach to portfolio analysis may prove useful since it can be empirically imple- mented. Utiity-based portfolio analysis has continued the traditional mean-variance approach with some attempts at ‘broadening the mean-variance utility function." Another alternative isto select another risk measure characterized by a general set of utility functions. One such measure proposed by Fishburn (1977) is the mdegree lower partial moment Specifically, the higher the degree of the LPM measure, the seater the risk aversion of the investor. The purpose ofthis paper is to propose two optimization algorithms using the redegree LPM and to test the ex post performance of the LPM algorithms Testing different degrees of the LPM is important for ‘wo reasons: first, there is a strong relationship between degree lower partial moment and stochastic dominance. This relationship is developed through the work of Bawa (1975, 1978), Bawa and Lindenberg (1977) and Fishburn (1977). These authors provide mathematic proofs that stochastic dominance is equivalent to all degrees of n-degree LPM. Bey (1979) provides empirical evidence that semi- variance (ES) efficient portfolios are part of the second- degree stochastie-dominance (SSD) (60-65%) and the third- degree stochastic-dominance (TSD){90% efficient sets. This relationship of the n-degree LPM to stochastic dominance is important since stochastic dominance does not make any distributional assumptions and assumes a very general set of Utility functions. Since stochastic dominance cannot be used as an algorithm to efficiently select optimal security alio- cations, a lower partial moment algorithm that closely approximates the stochastic-dominance efficient set may prove useful for portfolio selection. Secondly, Fishburn (1977) shows that by varying the degree of the n-degree lower partial moment, the isk measure can accurately reflect (when compared to semivariance-co-semivariance and variance-covariance analysis) investor utility towards risk and below-target returns ie the utility functions defined by n-degree LPM are as general as the utility functions defined by stochastic dominance. While Levy and Markowitz (1979) and Kroll et al. (1984) have found that a limited number of utility functions can be approximated by a judiciously chosen utility fanction defined by mean-variance, the n-degree LPM defines a general class of utility functions. Because of the potential benefits of an n-degree LPM algorithm, two LPM algorithms are proposed and tested. Using stochastic domi- ‘nance, the performance of the two algorithms is compared to the traditional variance-covariance portfolio analysis. ‘See Levy and Markowitz (1979), Aivazian et al. (1984) and Kroll etal. (1984) for a discussion of this area. (003 684691 $0304.12 © 1997 Chapman and Hall Led 465, Copyright © 2001 All Rights Reserved466 ‘The structure ofthis paper is a follows: First, a discussion of some issues concerning the LPM is presented. Secondly, the two LPM critical-line algorithms are described along with the methodology of the empirical test, Finally, the empirical results are presented along with concluding comments, Il. SOME RELEVANT ISSUES The computational formula for N-degree LPM and CLPM. Bawa (1975, 1978) and Fishburn (1977), in developing the sclationship between LPM and stochastic dominance, define n-degree LPM as follows: LPM,(h, F f (h— RPGR) a This yields the following computational formulas for LPM and CLPM (co-lower partial moment). LPM, t F (Max, RT Q CLPMyy x=) S [Max(0,(h—Ry Ry) 0) where his the target return, mis the number of observations, nis the LPM degree, and R,, is the periodic return for security i during period « This form of the calculation means that LPM is non- negative forall values ofn. N-degree LPM is not comparable to the standard statistical moments ofthe distribution where investors exhibit a preference for higher values of odd moments (skewness) and a dislike for higher values of even moments (variance, kurtosis)? LPM is based on the in- vestor's risk attitude towards below-target (h) returns Whenever n I, the investor i risk-averse and will prefer lower values of LPM and dislike higher values of LPM. As the degree of the LPM jis increased, the more the investor is averse to below-target returns. Skewness and LPM LPM, by measuring below-target returns, isis approximate measure of skewness in the distribution. Since investors prefer positive skewness and dislike negative skewness, LPM becomes a measure of risk. The higher the LPM value, the greater the degree of negative skewness and the greater the risk of the investment, As n increases, LPM is still measuring negative skewness. It is simply providing heavier utility penalty to negative skewness as the degree (n) is increased. 28ee Scott and Horvath (1980), SRemember that n=46 was the maximum value in Fishburn’s (1977) survey of investor utility functions, D.N. Nawrocki Higher degrees of N-degree LPM Fishburn (1977) provides general proof that states that first- degree stochastic dominance (FSD) includes all LPM-effi- ‘cient portfolios with n>0, Second-degree stochastic domin- ance (SSD) contains all LPM-efficient portfolios for n> 1 Third-degree stochastic dominance (TSD) contains all LPM ffcient portfolios for n>2. Note that N-degree LPM is not limited to a maximum of n=2 and that degrees greater than 2 are also part of the TSD-efficient set, Fishburn discusses a ‘number of individual utility functions where the LPM n ‘values range from less than 1.0 to as high as 46, Therefore, LPM degrees greater than 2.0 should also be included in empirical tests of the LPM measure. I. TWO N-DEGREE LPM ALGORITHMS This paper will test two optimal allocation algorithms for nedegree LPM. The first algorithm is developed from the following equations that calculate the n-degree portfolio LPM for s securities: LPMy=¥¥ X,X,CLPMyy-1 @ where CLPM yx y= LPM, when i=) 6) CLPM yxy ACLPMyx-1 when Hj (6) nel o Where the objective would be to minimize the portfolio LPM, With the CLPM being calculated according to Equation 3, Hogan and Warren (1972) derive Equation 4 assuming and the underlying distribution has a finite variance. At this point, the algorithm is stated as follows: Min = FS X,X,CLPMy-1 @ Next, the CLPM matrix in Equation 8 is input into a standard critical-line algorithm for maximizing portfolio return and minimizing some risk measure, z. The degrees n are varied from 1 to 5.’ This algorithm will be referred to as the Asymmetric LPM Algorithm (ALPM) because of the inequality in Equation 6, ‘A second heuristic algorithm is tested for comparison purposes to sce whether a simpler CLPM matrix improves portfolio performance. Elton et al. (1978) provide the motivation for this algorithm. Their empirical evidence indicates that a simple algorithm can forecast better than a complex optimal algorithm. In this algorithm, the n-degreeOptimal algorithms and lower partial moment: ex post results se i deviation (SD) is calculated in the following manner. soun{ = (Max. h—R0 Ff ° The CLPM is now calculated as & symmetric measure (CLPM,=CLPM,). CLPMy=(SD,)(SDy)¢4) 0) where ris the correlation coefBcient between securities J and J: Again Equation 8is used to formulate the problem and the critca-line algorithm is used to maximize retum and minimize 2. This algorithm will be referred to as the Symmetric LPM Algorithm (SEPM). The traditional variance-covatiance Markowitz algorithm will be referred to as the Covariance algorithm Anexample may be needed in order to appreciate thatthe symmetric matrix model is compatible with the mdegiee ZPM model. Table | below shows two investments A and B with the sameexpected return and variance. When n<1, Ais the preferred investment (0.630 for A compared to 1.264 for B, n=0.5) and when n>1, B is the preferred investment (6.320 for A compared to 3.162 for B, n= 1.5). Note that as n Increases, the LPM measure is placing a greater utlity penalty on investment A because ofits negative skewness Note that the nth root semi-deviation (SD) provides the same ullity penalty a5 increases, IV, METHODOLOGY ‘The SLPM and ALPM algorithms are tested along with the traditional variance-covariance algorithm using monthly ‘Table 1. Exaonple of N-degree LPM and semi-deviation a B Return Prob, Return Prob. =250 020 500080 750 010 1750 020 1000 070 Summary of location, scale and skewness of the two distributions Investment A nth root SDB E.R) 7.500 7.500 Variance 25.000 25000 1383 1.500 063003969 1268 6320 3.4183 3.162 20000 4472 5.000 600.000 84343 12.500 467 relative return data [(P,+ D,)/P,_. for 125 securities for the period 1952-77 from the University of Chicago, Center for Research in Security Prices (CRSP) data tape. The securities were randomly selected from the universe of NYSE stocks that had complete data for the period.* The portfolio performance is simulated using 72-month historic estimation period with a subsequent 60-month holding period, a 48-month historic period with a sub- sequent 24-month holding period and a 24-month historic period with a subsequent 12-month holding period. The estimation and holding periods were chosen as representat- ive of an actual implementation of the portfolio theory management process. The shorter 24-month estimation period will introduce estimation error into the covariance matrix; however, the covariance matrix is being used for forecasting purposes in this implementation rather than for inference purposes. Therefore, it is appropriate to study the 24-month period. The longer 72- and 48-month estimation periods are long enough to avoid errors in estimating the inputs.® ‘The 1952-57 period is used to obtain initial estimates for ‘expected returns and risk measures and the holding periods ‘commence in January 1958 and end in December 1977 for a total of 240 months.* Therefore, statistical estimation error should not enter into the ex-post evaluation of the simulated portfolio strategies. ‘The portfolios are revised at the end of cach holding period using a 1% transaction fee. Portfolio returns (for portfolio sizes of 5, 10 and 15 securities) over the 1958-77 period are generated and evaluated using terminal wealths, reward to semivariability and second-degree stochas dominance. The target value selected for calculating the rth root SD 15976 21543, 22361 23208 ‘Survival bias has not been found to have a significant effect on empirical results. See Ball and Watts (1979) and Sunder (1980). 8Sce Kroll and Levy (1980) for a study on estimation error. A second data set containing more recent data (1972-87) was also tested, Because of corporate restructuring that occurred in the 1980s, nly 100 ofthe original 125 securities were available for study. The empirical results from this data support the same conclusions that are derived from the original study. Therefore, they are not presented. Copyright © 2001 All Rights Reserved468 Table 2. Average number of securities in maximum security size portfolio generated by critical-tine algorithm D.N. Nawrocki Table 3, Average terminal wealth calues for optimal portfolio algorithms Historic-Holding R60 48-24 2412 Covariance 2300 2120 1800 Symmetsic LPM (SLPM) degree=0.0 2450 21.20 1580 10 1875 1790 1480 20 1775 17901395 30 1825 1840 16.10 40 1900 18201540 50 1925 1950 16.25 Asymmetsic LPM (ALP) degree = 10 500 980 9.85 20 1225 12101190 30 1798 14801470 40 1975 1280 1225 50 1275 1300 860 CLPM matrix is a 0.5% monthly return (6.2% annual), The degree of the LPM (n)is varied from 1 to 5. Corner portfolios are generated by a critcal-line algorithm (The EVES pro- ram from the Portfolio Management Software Package by ‘Nawrocki (1988) was modified to perform n-degree LPM analysis) and the first comer portfolio to contain 5 (10 and 15) securities is selected for the investment simulation Because the ALPM algorithm consistently sclected a smaller number of securities, only five securities and ten security portfolios are evaluated for the ALPM algorithm. V. EMPIRICAL RESULTS Number of securities chosen by the algorithms The first result of interest isthe average number of securities in the maximum security size portfolio generated by the criticaltine algorithm. In other words, the corner portfolio with the largest number of securities is the maximum security size portfolio. The results are provided in Table 2. For the most part, the variance-covariance algorithm pro- vides the largest average number of securities in a portfolio (2073). The symmetric algorithm (SLPM) allocates a smaller average number of securities (17.42) and the asym- metric algorithm (ALPM) chooses the smallest average number of securities (12.52). For most of the algorithms, there is 2 declining trend (decreasing number of securities) as the estimation-holding period is reduced from 48-24 to 24-12. This reduction is probably related to increased noise (and estimation error) in the covariance matrix due to the smaller number of observations in the estimation period Two observations can be made from this table. First, the LPM algorithms need fewer securities in order to achieve Hist. 72. Hist. 48. Hist 24. Hold. 60 Hold. 24 Hold. 12 Covariance 9.09 582 Symmetric LPM degrees 10 87 705 an 20 849 899 ws 30 814 894 1059 40 193 1027 1007 50 7182 130 13.60 Asymmetric LPM degree 10 626 995 304 20 650 368 454 30 1521 1095 390 40 BM 412 370 50 1501 242 762 their risk minimization (2), The fact that the ALPM al- gorithm selects fewer securities is an expected result, since the LPM/CLPM analysis is an approximate measure of the skewness ofthe security distribution and uses this informa- tion to influence portfolio choice. A number of researchers” show that positive skewness is diversified away by as few as six or seven securities. In order to obtain the benefits of positive skewness, less diversified portfolios are chosen. The results for the asymmetric algorithm are consistent with these earlier findings. Terminal wealth results Table 3 presents the results of the portfolio simulations from 1958 to 1977. In this table, risk is ignored and only the final wealth of the portfolios is reported. Ifan investor has a long- term investment horizon, then the terminal wealth is the appropriate measure of investment performance. A terminal ‘wealth of 7.21 is interpreted as an initial investment of $1 in 1958 growing to $7.21 by the end of 1977. For the 72-month historic period and 60-month holding period simulation, the ALPM algorithm provides the largest final wealths. The higher degree LPM (n>2) algorithms earn the highest returns, During the 48-24-month simulation, the SLPM al- gorithms enjoy the best performance with the terminal wealth increasing with the degree of the LPM measure. During the 24-12-simulation period, the SLPM al- gorithm enjoys the highest terminal wealths and again, the terminal wealth increases as n increased. In all cases (72-60, 48-24 and 24-12) the higher order (n>2) LPM measures provide the best investment per- formance. In all cases, the covariance algorithm had lower final wealths than one or both of the LPM algorithms. *Simkowitz and Beedles (1978), Duvall and Quinn (1981) and Kane (1982).Optimal algorithms and lower partial moment: ex post results 469 Reward to semivariability results In order to measure the risk/return performance of the algorithms, reward to semi-variability (R/SV) ratios are computed and presented in Table 4. The Sharpe and Treynor measures that are typically used are statistically biased. Ang and Chua (1979) demonstrate this bias and show the R/SV ratios to be unbiased performance measures. With 240 monthly observations, the results are not expected to be affected by estimation error. The results in Table 4 are identical to the terminal wealth results in Table 3, The ALPM algorithm has the best results with the 72-60 simulation (degrees of 3, 4 and 5). The SLPM_ provides the best performance with the 48-24 and with the 24-12 simulations Second-degree stochastic dominance results Tables 3 and 4 cannot be subjected to statistical analysis ‘because ofthe criticisms made by Fishburn (1977) concern- ing the distribution or utility assumption behind the statist ical test. In fact, both the terminal wealth and the R/SV techniques assume restrictive utility functions. In order to draw any conclusions, a performance measure that satisfies Fishburn’s objections needs to be used. The second-degree stochastic dominance (SSD) meets this need since it does not make any distributional assumption and utilizes a very general utility function (for all n> 1, which describes all isk- averse behaviour when risk is measured with below-target returns) ‘The portfolios that are second-degree stochastic domin- ant are determined using the Porter et al. (1973) algorithm corrected for the Vickers and Altman (1979) bias Table 4. Average reward 10 semivariability ratios for optimal algorithms Hist 72 Hist. 48 Hist. 24 Hold-60 —Hold-24 —Hold-12 Covariance 0.1708 01129 o14s4 Symmetric LPM 10 0.1705 01458 0.1658 20 o.1648 0.1763 0.1904 30 0.1575 0.1683 01971 40 0.1550 0.1940 0.1880 50 ou47 0.2053 02240 Asymmetric LPM 10 0.1326 0.1805 oo274 20 0.1330 00591 0.0823, 30 0.2096 0.1980 0.0610 40 0.2009 00743 0.0589 50 0.1952 0.0086 01319 All of the portfolios denoted by X in Table 5 are SSD- efficient. For the 72-60 simulation, none of the algorithms exhibits a clear dominance over the other algorithms. It should be noted that EV-efficient portfolios are also part of, the SSD-efficient set.® Because SSD includes a broad range of utiity functions, both the ALPM and SLPM algorithms provide a valid alternative to mean-variance analysis by simply being included in the SSD-effcient set. With the 48-24-month simulation periods and the 24-12- ‘month periods, both the ALPM portfolios and the covari- ance portfolios are dominated by the SLPM algorithm. Here it is clear that the SLPM model is providing performance that is superior to mean-variance analysis. The results are sensitive to the length of the historic and holding period. With the shorter historic-holding periods (48-12 and 24-12), the SLPM algorithms dominate the variance-covariance algorithm. The shorter subperiods may place a premium on forecasting ability and the SLPM may simply be the better forecast model as per Elton et al. (1978), ‘The ALPM model and the covariance model provide theit best performance during the longer 72-60 simulation. Both of the LPM algorithms exhibit very good performance from using higher degrees of LPM (n>2). The main conclusion from these results is that LPM analysis provides investment performance that is very competitive with traditional co- variance analysis, thus broadening the range of utility choices available to investors. In addition, these results Table 5. Second-degree stockasticdominance results for optimal portfolio algorithms using covariance and co-lower partial moment ‘analysis for 125 securities from 1958 to 1977 Hist. 72. Hist 48. Hist. 24- Hold. 60 Hold.24 Hold. 12 Num. Stocks S wis $ Wis 5 1015 Algorithms covariance xx Symmetric LPM degree = 10 x x x 20 x xX x x 30 x Kx 40 x x x x 50 x Rie ‘Asymmetric LPM degree = 1.0 x 20 x 30 x 40 x x 50 x X-undominated by SSD 'See Saunders etal. (1980) for a discussion of using stochastic dominance for portfolio evaluation *See Bey (1979). Copyright © 2001 All Rights Reserved470 indicate that future empirical tests of the lower parti: moment should include the higher LPM moments. VI. SUMMARY AND CONCLUSIONS This study tests two algorithms that employ higher degrees of the n-degree lower partial moment risk measure in order to provide investors with a broader range of ulility choices. ‘The first algorithm, the asymmetric matrix algorithm {ALPM), derives from the optimal Hogan and Warren (1972) semivariance algorithm. The second algorithm, the symmetric algorithm (SLPM), is an ad hoc heuristic that simplifies the CLPM matrix. The two algorithms are tested along with the traditional variance-covariance algorithm, Portfolio performance is evaluated using terminal wealth, reward to semivariability and stochastic dominance. For historic estimation periods of 72 months and sub- sequent holding periods of 60 months, the stochastic dominance results indicate that no portfolio algorithm consistently dominates the others, All of the algorithms are providing portfolios that are members of the second-degree stochastic-dominance efficient set. Even though the LPM portfolios are not superior to covariance analysis, they are providing investors with different utility choices because they are members of the SSD-eficient set. Support for this statement also comes from the terminal wealth and reward to semivariability results that indicate that the LPM algorithms are either comparable or superior to covariance analysis, For shorter periods such as 48-24-month and 24-12 month historic/holding periods, the SLPM algorithm util- izing higher LPM moments clearly dominates the other two algorithms. Overall, the SLPM portfolios provide the most consistent performance. The optimat ALPM algorithm per- forms well only during the longer 72-60-month sub-periods. Because of its added complexity, the ALPM algorithm does not have the empirical support to recommend it Since the SLPM algorithms provide portfolios that are members of the SSD-effcient set when compared to the traditional covariance algorithm, the SLPM algorithms have to be considered a viable alternative to covariance analysis. The fact that SLPM analysis handles a broader range of investor utility functions increases the attract iveness of the technique. ACKNOWLEDGEMENTS The author wishes to thank Ghassem Homaifar for his valuable contributions to this paper, particularly Table 1 D.N. Nawrocki REFERENCES Aivazian, V, Ay Callen, J. L., Krinsky, Land C.C. Y. Kwan (1983) Mean-variance utility functions and the demand for risk assets: an empirical analysis using flexible functional forms, Journal of Financial and Quantitative Analysis, 18, 41124 ‘Ang, JS. and Chua, J. H. 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