Finance Research Letters xxx (xxxx) xxx

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Finance Research Letters

journal homepage: www.elsevier.com/locate/frl

Optimized portfolio using a forward-looking expected tail loss

Anthony Sanford
University of Maryland, College Park, 4113AA Van Munching Hall, MD 20742, United States of America

ARTICLE INFO ABSTRACT

JEL classification: In this paper, I construct an optimal portfolio by minimizing the expected tail loss derived from
G00 the forward-looking natural distribution of the Recovery Theorem. This natural distribution
G1 can be used as the criterion function in an expected tail loss portfolio optimization problem. I
G12
find that the portfolio constructed using the Recovery Theorem outperforms both an equally-
Keywords: weighted portfolio and a portfolio constructed using historical expected tail loss. The portfolio
Recovery theorem constructed using the Recovery Theorem has the smallest historical tail loss, smallest maximum
Portfolio theory
drawdown, highest Sortino Ratio, and highest Sharpe Ratio.
Expected tail loss
Expected shortfall
Portfolio optimization

1. Introduction

Portfolio theory plays an important role in the everyday lives of millions of investors. In 1952, Markowitz (1952) laid the
groundwork for the field of portfolio theory. Markowitz argued that an investor wanted to not only maximize return on their
investment portfolio, but that they also wanted to minimize its variability. The portfolio optimization proposed by Markowitz was
the idea of mean–variance optimization, where the investor maximizes return for a given level of risk. Since Markowitz (1952),
however, the field of portfolio theory has moved well-beyond mean–variance optimization. This paper shows that, by constructing
a portfolio that minimizes the tail of the expected natural probability distribution of returns, we obtain risk-adjusted returns that
are higher than when using other popular methods of portfolio construction. The Recovery Theorem (RT) (Ross, 2015) allows us to
obtain a forecast of the distribution of returns that is not based on historical information, a common concern in portfolio theory.
Instead, the RT uses the forward-looking nature of option’s in its construction of expected future returns.
In past research, there has been several issues with the use of option-based distributions of expected returns in portfolio theory
because risk-neutral densities (RND) are known to not be accurate measures of future expected returns (Canina and Figlewski,
1993). One of the major reasons for why the RND is unable to accurately forecast returns is because it does not accurately portray a
representative investors risk aversion. Only if investors were, on average, risk-averse, would the RND be able to capture the future
expected returns of assets accurately. As such, more recent research has focused on the estimation of a risk-adjusted RND as a way
of forecasting returns for use in portfolio analysis. For example, Cecchetti and Sigalotti (2013) accomplishes this by adjusting the
RND for risk-aversion using the Berkowitz test to derive the risk-aversion coefficient (another method is proposed by Sun et al.
(2016)). These methodologies, however, still rely on ad-hoc ways of adjusting the RND for risk-aversion. The natural probability
distribution derived using the RT addresses the issue of deriving a probability density of returns without making any assumptions
of risk-neutrality.
One of the major advances in portfolio theory and risk management has been in the development of measures that minimize
tail losses. This paper constructs a portfolio using the expected tail loss risk measure (ETL) (Tasche, 2002; Alexander and Baptista,

E-mail address: sanfoan@umd.edu.

https://doi.org/10.1016/j.frl.2021.102421
Received 5 July 2021; Received in revised form 9 August 2021; Accepted 31 August 2021
Available online 8 September 2021
1544-6123/© 2021 Elsevier Inc. All rights reserved.

Please cite this article as: Anthony Sanford, Finance Research Letters, https://doi.org/10.1016/j.frl.2021.102421
A. Sanford Finance Research Letters xxx (xxxx) xxx

2004).1 The ETL method falls into the ‘‘safety-first’’ category of risk measures where the classical approach (Roy, 1952) is to minimize
the probability that a risk variable will not exceed a threshold (e.g. 𝑚𝑖𝑛 𝑃 (𝑅𝑝 ≤ 𝑅0 ) where 𝑅0 is our risk threshold). In comparison,
the expected tail loss measure is concerned with minimizing the average expected portfolio loss below a threshold. Specifically, I
use the methodology proposed by Rockafellar et al. (2000), Rockafellar and Uryasev (2002). One concern, however, when using
risk-measures is that the construction of the distribution to be optimized is either based on parametric assumptions or historical
data (Gourieroux and Jasiak, 2001; Markowitz, 1952). The use of the RT is particularly useful in this instance because it provides us
with a nonparametric distribution of expected returns that is forward-looking (the RT does not use historical data) and risk-adjusted.
In this paper, I find that the portfolio constructed using the RT outperforms both an equally-weighted portfolio and a portfolio
constructed using historical ETL. The portfolio constructed using the RT has the smallest historical tail loss, smallest maximum
drawdown, highest Sortino Ratio, and highest Sharpe Ratio.

2. Model

Using the natural probability distribution derived from option prices using the RT, one can obtain the weights for an efficient
portfolio. The natural probability distribution represents the forward-looking expected distribution of returns for an option’s
underlying asset. I propose to leverage the information in option prices by constructing a portfolio of assets that is optimized by
minimizing the left tail (the worst expected outcomes for assets in the portfolio) of the natural distribution of assets to be included
in the portfolio.

2.1. Expected tail loss

To optimize our portfolio, I propose to use the minimization of the expected tail loss (ETL). I choose to use ETL because it lends
itself well to the use of the RT since the RT gives us a forward looking distribution of returns. As such, it makes both intuitive and
mathematical sense to use ETL. The optimization problem that will be used throughout the rest of this paper is as follows:
1
1
min 𝐸𝑇 𝐿𝛼 (𝐿) = 𝑉 𝑎𝑅𝑢 (𝐿)𝑑𝑢
𝑤𝑖 1 − 𝛼 ∫𝛼
𝑠.𝑡. 𝑉 𝑎𝑅𝑢 (𝐿) = 𝑖𝑛𝑓 {𝑥 ∈ R ∶ 𝐹 (𝑥) ≥ 𝛼} (1)
∑
𝑛
𝑤𝑖 = 1
𝑖=1

where 𝛼 is our confidence level, 𝐿 is portfolio loss, 𝐹 (𝑥) = 𝑃 (𝐿 ≤ 𝑥) is the distribution of losses at the end of an arbitrary time
horizon, and 𝑉 𝑎𝑅 is our measure of value-at-risk. In essence, we are choosing the weights of each asset in the portfolio to minimize
the expected loss of our portfolio beyond a certain threshold (this threshold is given by 𝛼) subject to investing all our money
∑
( 𝑛𝑖=1 𝑤𝑖 = 1). For this paper, we are allowing for the use of short sales.

2.2. The natural probability distribution

Using the RT, we will derive our expected distribution using the natural probability of returns, 𝐹 . This empirical distribution
will then be used in the optimization defined in Eq. (1). The RT makes use of state prices (Breeden and Litzenberger, 1978) to
disentangle its components into the discount rate, pricing kernel, and the natural probability distribution. The version of the RT
used in this paper is based on the RT described in Sanford (2017, 2021).
Beyond the interpolation of option prices, deriving the RT involves three major steps: state price estimation (see Sanford (2021)),
contingent state price estimation, and natural probability distribution recovery. Ross (2015) estimates the contingent state price
matrix using the following equation:

𝑠𝑡+1 = 𝑠𝑡 𝑃 , 𝑡 = 1, … , 𝑚 − 1 (2)

where 𝑚 is the number of states and 𝑃 is the contingent state price matrix. Once we have obtained the contingent state price matrix,
we can proceed to apply the RT. Assuming a representative agent framework:

𝑈𝑖′ 𝑝𝑖𝑗 = 𝛿𝑈𝑗′ 𝑓𝑖𝑗 , (3)

which can then be written in continuous time and in terms of the pricing kernel:
ℎ(𝜃𝑗 )
𝜙(𝜃𝑖 , 𝜃𝑗 ) = 𝛿 (4)
ℎ(𝜃𝑖 )
where 𝜃𝑖 is the current state. Using Eq. (4) and assuming transition independence, we have:
ℎ(𝜃𝑗 )
𝑝(𝜃𝑖 , 𝜃𝑗 ) = 𝜙(𝜃𝑖 , 𝜃𝑗 )𝑓 (𝜃𝑖 , 𝜃𝑗 ) = 𝛿 𝑓 (𝜃𝑖 , 𝜃𝑗 ) (5)
ℎ(𝜃𝑖 )

1 Also known as expected shortfall and conditional Value-at-risk.

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Table 1
Descriptive statistics for the return series.
Statistic N Mean St. Dev. Min Lower quartile Median Upper quartile Max
NASDAQ 100 231 0.006 0.069 −0.264 −0.024 0.011 0.047 0.195
Russell 2000 231 0.007 0.055 −0.209 −0.029 0.011 0.042 0.164
S&P 500 231 0.004 0.042 −0.169 −0.018 0.009 0.030 0.108
VIX 231 0.017 0.217 −0.385 −0.111 −0.016 0.108 1.346

Table 2
Summary statistics for the performance of the individual assets.
Statistic Mean St. Dev. Skew Kurt ETL Maximum drawdown SR1 SR2
NASDAQ 100 0.0047 0.0707 −0.5239 1.5838 0.2351 0.4592 0.0669 0.0929
Russell 2000 0.0066 0.0571 −0.3617 0.6475 0.1656 0.3732 0.1167 0.1710
S&P 500 0.0035 0.0425 −0.5552 1.0799 0.1298 0.2661 0.0825 0.1153
VIX 0.0158 0.2152 1.7247 7.0736 0.3613 1.7306 0.0738 0.1381

where ℎ(𝜃) = 𝑈 ′ (𝑐(𝜃)), and 𝑝(𝜃𝑖 , 𝜃𝑗 ) is the state price transition function that we observe. The objective is to solve for the unknowns:
ℎ(𝜃 )
the natural probability transition function 𝑓 (𝜃𝑖 , 𝜃𝑗 ), the kernel 𝜙(𝜃𝑖 , 𝜃𝑗 ) = 𝛿 ℎ(𝜃𝑗 ) , and the discount rate 𝛿. In discrete time, we can
𝑖
rewrite Eq. (5) as:

𝐷𝑃 = 𝛿𝐹 𝐷 (6)

where 𝑃 is the matrix derived in Eq. (2), 𝐹 is the matrix that we are calling the natural probabilities, and 𝐷 is the marginal rate of
substitution. We obtained 𝑃 in Eq. (2), so now 𝐷 must be estimated. Assuming that 𝑃 is nonnegative and irreducible, we can apply
the Perron–Frobenius Theorem, which states that all nonnegative and irreducible matrices have a unique positive characteristic root
(eigenvector) 𝑧, and a Perron root 𝛿 (eigenvalue). This allows us to solve for 𝐷, which we can introduce in the true distribution
equation:
1
𝐹 = 𝐷𝑃 𝐷−1 (7)
𝛿
Using the natural probability distribution to obtain an expected distribution of returns for several assets, we can then use these
distributions to construct a portfolio.

3. Results

3.1. Data

The data for this paper comes from the Wharton Research Data Services (WRDS) database. Data was gathered for four assets: the
S&P 500, the Russell 2000, the VIX index, and the NASDAQ 100. State discretization for the RT was constructed such that future
returns are +/- 5 standard deviations (e.g. -5, -4, . . . ,+4,+5) for a total of 11 states. Time discretization was constructed monthly
(e.g. 1-month, 2-months, . . . , 12-months) for a total of 12 time states. Details for the derivation of the state price density variable is
outlined in detail in Sanford (2021). For simplicity, users can obtain SPD data from Bloomberg directly without a significant impact
on the end portfolio results.
For the historical ETL portfolio, I construct a distribution of returns that is based on ten years of historical monthly data (January
2000 to January 2010) obtained from CRSP. Using this distribution, I select the weights that minimize the joint portfolio distribution
(5% lower tail). For the portfolio constructed using the RT, I use monthly option prices obtained from the OptionMetrics database.
The risk-free rate is the one-month Treasury Bill rate. S&P 500 prices are from the CRSP dataset.
The descriptive statistics are presented in Table 1. The NASDAQ 100, the Russell 2000, and the S&P 500 are all broad indices
that represent broad markets. As such, they are all relatively similar in terms of historical monthly returns (but not in terms of
correlations). These range from 0.004 for the S&P 500 to 0.007 for the Russell 2000. All of them also have similar risk levels (the
NASDAQ 100 has the highest standard deviation at 0.069). The only exception would be from the VIX index, where the average
monthly return is approximately 1.7%. As one would expect, that higher average return comes with higher volatility of 21.7%.
Table 2 shows the average Sharpe and Sortino ratios for the four assets (SR1 and SR2, respectively). The higher the values for
these measures, the better. The higher relative risk associated with the VIX is apparent in Table 2. The highest average Sharpe
ratio (Sharpe, 1994) is from the Russell 2000 index at around 0.12 while the lowest Sharpe ratio is from the NASDAQ 100 index
at about 0.067. By comparison, the Sharpe ratio of the optimal portfolio (using the RT) increases almost fourfold when compared
to the highest Sharpe ratio of the individual indices.

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Fig. 1. Time-series of the equally weighted portfolio.

Fig. 2. Time-series of the portfolio constructed using historical returns.

3.2. Portfolio time-series results

As a first benchmark scenario, I invest in an equally weighted portfolio for the duration of the sample period. In this portfolio
construction, I rebalance every month to ensure that the portfolio maintains its equal weight in each asset. Fig. 1 presents the time
series for the realized return for the equally weighted portfolio. I obtain an average monthly return of about 1.306%, a standard
deviation of 0.0473, a Sharpe Ratio of approximately 0.2763, and a Sortino Ratio of approximately 0.7456. The maximum drawdown
for the equally weighted portfolio is 0.3470.
Fig. 2 shows the results for the optimized portfolio using the historical distribution of returns. I obtain an average monthly return
of about 1.120%, a standard deviation of 0.0341, a Sharpe Ratio of approximately 0.3517, and a Sortino Ratio of approximately
0.9816. The maximum drawdown for the historical based optimized portfolio is 0.2476.
Fig. 3 shows the time-series graph of the portfolio returns optimized using the RT. I obtain an average monthly return of about
1.1030%, a standard deviation of 0.0269, a Sharpe Ratio of approximately 0.4049, and a Sortino Ratio of approximately 1.0645.
The maximum drawdown for the RT-based optimized portfolio is 0.1973.

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Fig. 3. Time-series of the portfolio optimized using the RT.

3.3. Comparisons across optimization methods

Table 3 summarizes the major findings. Panel A reports the findings for the method proposed in this article. Panels B through E
report various robustness checks. Panels B and C present the results for sample subsets (panel B is from January 2010 to January
2014 while panel C is for January 2014 to December 2017). Panel D shows results when a mean–variance optimization is used.
Panel E shows the results when I estimate the state price density using the Aït-Sahalia and Lo (1998) method.2 The reported statistics
include: mean, standard deviation, excess skewness, excess kurtosis, expected tail loss, largest observed loss of the portfolio from a
peak to a trough (‘‘maximum drawdown’’), Sharpe Ratio (‘‘SR1’’), and Sortino Ratio (‘‘SR2’’).
In panel A, the return for all three portfolios are quite similar to one another. Yet, the RT portfolio produces much lower risk
overall, regardless of the risk measure used. The equally weighted portfolio produces the highest return, but at the expense of a
much larger volatility. The volatility of the equally weighted portfolio is almost twice as high as the volatility for the portfolio
constructed using the RT. This pattern persists in all of the robustness checks with the exception of the mean–variance optimization
presented in panel D. Here, the RT method has higher returns but also higher risk. That being said, when looking at the Sortino
ratio, the RT ETL method outperforms the historical ETL method. This is because the RT introduces more upside volatility, which
is desirable ‘‘risk’’.
The skewness for the distributions also appears to be quite similar (except in the case of the first sample subset, panel B). The
measure of kurtosis, however, varies quite substantially. The largest kurtosis is for the equally weighted portfolio. This indicates
that this distribution exhibits the fattest tails in its distribution: we are more likely to observe extreme swings in the returns in this
portfolio than in the others. Risk-averse investors prefer a smaller kurtosis. In the mean–variance optimization scenario, the RT has
the largest kurtosis. Again, however, this is in large part because of the large upside swings in portfolio returns.
The ETL measure is the 5% expected tail loss measure for each of the portfolios. Here, again, we can see that the equally weighted
portfolio has a much larger expected tail loss than the other two portfolios. This should make intuitive sense since we constructed
the other two portfolios such that the ETL was minimized. Again, the portfolio with the lowest ETL was the portfolio constructed
using the RT. For the MV optimization (panel D), the two values are very similar to one another. In terms of maximum drawdown,
again, the portfolio constructed with the RT offers a much lower maximum drawdown than the other two methods (in panel A). In
particular, the maximum drawdown for the equally weighted portfolio is almost twice as large as the maximum drawdown for the
portfolio constructed using the RT. In subsample I (panel B), the maximum drawdown for the RT is slightly larger than the other
portfolios. For the MV optimization (panel D), the maximum drawdown is about a third smaller than for the historical MV portfolio.
The last two measures analyzed here are the Sharpe Ratio and the Sortino Ratio. Both are single-value summaries of the risk-
adjusted return of a portfolio. Again, and in general, the portfolio constructed using the RT provides us with the largest return
adjusted for two different levels of risk. The only exception being the MV optimization method where the historical-based MV
portfolio has a lower Sharpe ratio, but the RT-based portfolio has the higher Sortino ratio.

2 The method of Aït-Sahalia and Lo (1998) (ASL) was presented in this section because it is a widely used method for estimating the SPDs. We tested several

different parameter values, methods, and data sources and found that the results presented in this section are robust to these SPD estimation differences. We
only present results for the ASL method for brevity.

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Table 3
This table presents results for all portfolios. Panel A is the results for the proposed method of this paper. Panels B through E are robustness checks. Panel B
shows the results for the first half of the sample (January 2010 to January 2014). Panel C shows the results for the first half of the sample (January 2014 to
December 2017). Panel D shows the results for a mean–variance (MV) optimization. Panel E shows the results when a different SPD method is used to obtain
the RT.
Statistic Mean St. Dev. Skew Kurt ETL Maximum drawdown SR1 SR2
Panel A: ETL Results
Equally weighted 0.0131 0.0473 2.4403 11.2733 0.05102 0.3470 0.2763 0.7456
Historical ETL 0.0119 0.0341 1.9773 7.7435 0.03827 0.2476 0.3516 0.9816
RT ETL 0.01103 0.0269 1.6957 7.4381 0.03526 0.1973 0.4071 1.0645
Panel B: Sample Subset I
Equally weighted 0.0130 0.0349 0.7742 0.5514 0.0373 0.0716 0.3708 0.9082
Historical ETL 0.0112 0.0282 0.7484 0.7751 0.0331 0.0641 0.3975 0.9759
RT ETL 0.0122 0.0239 0.2664 −0.3355 0.0295 0.0706 0.5100 1.2700
Panel C: Sample Subset II
Equally weighted 0.0135 0.0571 2.5465 9.7258 0.0584 0.1066 0.2371 0.6734
Historical ETL 0.0129 0.0391 2.2773 8.0833 0.0404 0.0548 0.3291 1.0081
RT ETL 0.0103 0.0303 2.3079 9.5849 0.0368 0.0520 0.3401 0.9283
Panel D: MV Optimization

Historical MV 0.0109 0.0249 1.1502 3.1494 0.0314 0.0686 0.4385 1.1450

RT MV 0.0128 0.0316 2.7363 14.1655 0.0322 0.0468 0.4050 1.2986
Panel E: Different SPD method
RT ETL 0.0114 0.0298 1.6715 5.3622 0.0363 0.0567 0.3839 1.0562

4. Conclusion

This article uses the information contained in the natural probability distribution derived from option prices to find the portfolio
weights from an expected tail loss minimization portfolio problem. Traditionally, portfolio theory has relied on parametric measures
of the return distributions, or empirical distributions based on historical returns. Using the natural probability distribution of
option prices obtained from the Recovery Theorem (Ross, 2015), one can estimate a nonparametric estimate of the forward-looking
distribution of returns. I find that the risk-adjusted return of the RT-based portfolio constructed in this paper outperforms the
returns from any of the two benchmark portfolios. An interesting extension to this line of research would estimate the RT returns
distributions with a copula (see, for example, Han et al. (2017)) to accurately estimate the dependence structure.

CRediT authorship contribution statement

Anthony Sanford: Conceptualization, Methodology, Software, Data curation, Writing – original draft, Visualization, Writing –
review & editing.

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