Robust EquityPortfolio

Management +Website

The Frank J. Fabozzi SeriesFixed Income Securities, Second Edition by Frank J. Fabozzi

Focus on Value: A Corporate and Investor Guide to Wealth Creation byJames L. Grant and James A. Abate

Handbook of Global Fixed Income Calculations by Dragomir Krgin

Managing a Corporate Bond Portfolio by Leland E. Crabbe and FrankJ. Fabozzi

Real Options and Option-Embedded Securities by William T. Moore

Capital Budgeting: Theory and Practice by Pamela P. Peterson and FrankJ. Fabozzi

The Exchange-Traded Funds Manual by Gary L. Gastineau

Professional Perspectives on Fixed Income PortfolioManagement, Volume 3edited by Frank J. Fabozzi

Investing in Emerging Fixed Income Markets edited by Frank J. Fabozzi andEfstathia Pilarinu

Handbook of Alternative Assets by Mark J. P. Anson

The Global Money Markets by Frank J. Fabozzi, Steven V. Mann, andMoorad Choudhry

The Handbook of Financial Instruments edited by Frank J. Fabozzi

Interest Rate, Term Structure, and Valuation Modeling edited by FrankJ. Fabozzi

Investment Performance Measurement by Bruce J. Feibel

The Handbook of Equity Style Management edited by T. Daniel Coggin andFrank J. Fabozzi

The Theory and Practice of Investment Management edited by FrankJ. Fabozzi and Harry M. Markowitz

Foundations of Economic Value Added, Second Edition by James L. Grant

Financial Management and Analysis, Second Edition by Frank J. Fabozziand Pamela P. Peterson

Measuring and Controlling Interest Rate and Credit Risk, Second Editionby Frank J. Fabozzi, Steven V. Mann, and Moorad Choudhry

Professional Perspectives on Fixed Income PortfolioManagement, Volume 4edited by Frank J. Fabozzi

The Handbook of European Fixed Income Securities edited by FrankJ. Fabozzi and Moorad Choudhry

The Handbook of European Structured Financial Products edited by FrankJ. Fabozzi and Moorad Choudhry

The Mathematics of Financial Modeling and Investment Management bySergio M. Focardi and Frank J. Fabozzi

Short Selling: Strategies, Risks, and Rewards edited by Frank J. Fabozzi

The Real Estate Investment Handbook by G. Timothy Haight and DanielSinger

Market Neutral Strategies edited by Bruce I. Jacobs and Kenneth N. Levy

Securities Finance: Securities Lending and Repurchase Agreements edited byFrank J. Fabozzi and Steven V. Mann

Fat-Tailed and Skewed Asset Return Distributions by Svetlozar T. Rachev,Christian Menn, and Frank J. Fabozzi

Financial Modeling of the Equity Market: From CAPM to Cointegration byFrank J. Fabozzi, Sergio M. Focardi, and Petter N. Kolm

Advanced Bond Portfolio Management: Best Practices in Modeling andStrategies edited by Frank J. Fabozzi, Lionel Martellini, and PhilippePriaulet

Analysis of Financial Statements, Second Edition by Pamela P. Peterson andFrank J. Fabozzi

Collateralized Debt Obligations: Structures and Analysis, Second Edition byDouglas J. Lucas, Laurie S. Goodman, and Frank J. Fabozzi

Handbook of Alternative Assets, Second Edition by Mark J. P. Anson

Introduction to Structured Finance by Frank J. Fabozzi, Henry A. Davis,and Moorad Choudhry

Financial Econometrics by Svetlozar T. Rachev, Stefan Mittnik, FrankJ. Fabozzi, Sergio M. Focardi, and Teo Jasic

Developments in Collateralized Debt Obligations: New Products andInsights by Douglas J. Lucas, Laurie S. Goodman, Frank J. Fabozzi, andRebecca J. Manning

Robust Portfolio Optimization and Management by Frank J. Fabozzi, PeterN. Kolm, Dessislava A. Pachamanova, and Sergio M. Focardi

Advanced Stochastic Models, Risk Assessment, and Portfolio Optimizationsby Svetlozar T. Rachev, Stogan V. Stoyanov, and Frank J. Fabozzi

How to Select Investment Managers and Evaluate Performance byG. Timothy Haight, Stephen O. Morrell, and Glenn E. Ross

Bayesian Methods in Finance by Svetlozar T. Rachev, John S. J. Hsu, BilianaS. Bagasheva, and Frank J. Fabozzi

The Handbook of Municipal Bonds edited by Sylvan G. Feldstein and FrankJ. Fabozzi

Subprime Mortgage Credit Derivatives by Laurie S. Goodman, Shumin Li,Douglas J. Lucas, Thomas A Zimmerman, and Frank J. Fabozzi

Introduction to Securitization by Frank J. Fabozzi and Vinod Kothari

Structured Products and Related Credit Derivatives edited by BrianP. Lancaster, Glenn M. Schultz, and Frank J. Fabozzi

Handbook of Finance: Volume I: Financial Markets and Instruments editedby Frank J. Fabozzi

Handbook of Finance: Volume II: Financial Management and Asset Man-agement edited by Frank J. Fabozzi

Handbook of Finance: Volume III: Valuation, Financial Modeling, andQuantitative Tools edited by Frank J. Fabozzi

Finance: Capital Markets, Financial Management, and Investment Manage-ment by Frank J. Fabozzi and Pamela Peterson-Drake

Active Private Equity Real Estate Strategy edited by David J. Lynn

Foundations and Applications of the Time Value of Money by PamelaPeterson-Drake and Frank J. Fabozzi

Leveraged Finance: Concepts, Methods, and Trading of High-Yield Bonds,Loans, and Derivatives by Stephen Antczak, Douglas Lucas, and FrankJ. Fabozzi

Modern Financial Systems: Theory and Applications by Edwin Neave

Institutional Investment Management: Equity and Bond Portfolio Strategiesand Applications by Frank J. Fabozzi

Robust EquityPortfolio

Management +Website

Formulations, Implementations,and Properties Using MATLAB

WOO CHANG KIMJANG HO KIM

FRANK J. FABOZZI

Copyright © 2016 by Woo Chang Kim, Jang Ho Kim, and Frank J. Fabozzi. All rightsreserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted inany form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

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Library of Congress Cataloging-in-Publication Data

Names: Kim, Woo Chang. | Kim, Jang-Ho. | Fabozzi, Frank J.Title: Robust equity portfolio management + website : formulations,

implementations, and properties using MATLAB / Woo Chang Kim, Jang Ho Kim,Frank J. Fabozzi.

Description: Hoboken : Wiley, 2015. | Series: Frank J. Fabozzi series |Includes index.

Identifiers: LCCN 2015030347 | ISBN 9781118797266 (hardback) |ISBN 9781118797303 (epdf) | ISBN 9781118797372 (epub)

Subjects: LCSH: Porffolio management. | Investments–Mathematical models. |Investment analysis–Mathematical models. | BISAC: BUSINESS & ECONOMICS /Investments & Securities.

Classification: LCC HG4529.5 .K556 2015 | DDC 332.60285/53–dc23 LC recordavailable at http://lccn.loc.gov/2015030347

Cover Design: WileyCover Image: © Danil Melekhin/Getty Images, Inc.

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

WCK

To my daughter, Joohyung

JHK

To my wife, Insun Jung

FJF

To my sister, Lucy

Contents

Preface xi

CHAPTER 1Introduction 1

CHAPTER 2Mean-Variance Portfolio Selection 6

CHAPTER 3Shortcomings of Mean-Variance Analysis 22

CHAPTER 4Robust Approaches for Portfolio Selection 39

CHAPTER 5Robust Optimization 66

CHAPTER 6Robust Portfolio Construction 95

CHAPTER 7Controlling Third and Fourth Moments of Portfolio Returns via RobustMean-Variance Approach 122

CHAPTER 8Higher Factor Exposures of Robust Equity Portfolios 137

CHAPTER 9Composition of Robust Portfolios 164

CHAPTER 10Robust Portfolio Performance 185

ix

x CONTENTS

CHAPTER 11Robust Optimization Software 216

About the Authors 231

About the Companion Website 233

Index 235

Preface

The mean-variance model for constructing portfolios, introduced by HarryMarkowitz, changed how portfolio managers analyze portfolios, espe-

cially for managing equity portfolios. The model provides a strong founda-tion for quantifying the return and risk attributes of a portfolio, as well asmathematically forming optimal portfolios. Following the 1952 publicationof Markowitz’s mean-variance model, there have been numerous extensionsof the original model, particularly starting in the 1990s, that have soughtto overcome criticisms of the original model. In this book, we focus on oneof these extensions, the construction of robust portfolios for equity port-folio management within the mean-variance framework. We refer to thisapproach as robust equity portfolio management.

The book will be most helpful for readers who are interested in learningabout the quantitative side of equity portfolio management, mainly port-folio optimization and risk analysis. Mean-variance portfolio optimizationis covered in detail, leading to an extensive discussion on robust portfoliooptimization. Nonetheless, readers without prior knowledge of portfoliomanagement or mathematical modeling should be able to follow the presen-tation, as basic concepts are covered in each chapter. Furthermore, the mainquantitative approaches are presented with MATLAB examples, allowingreaders to easily implement portfolio problems in MATLAB or similar mod-eling software. An online appendix provides the MATLAB codes presentedin the chapter boxes (www.wiley.com/go/robustequitypm).

Although this is not the only book on robust portfolio management,it distinguishes itself from other books by focusing solely on quantitativerobust equity portfolio management, including step-by-step implementa-tions. Other books, such asRobust PortfolioOptimization andManagementby Frank J. Fabozzi, Petter N. Kolm, Dessislava Pachamanova, and SergioM. Focardi, also introduce robust approaches, but we believe that readersseeking to learn the formulations, implementations, and properties ofrobust equity portfolios will benefit considerably by studying the chaptersin the current book.

Woo Chang KimJang Ho Kim

Frank J. Fabozzi

xi

CHAPTER 1Introduction

The foundations of what is popularly referred to as “modern portfoliotheory” is attributable to the seminal work of Harry Markowitz, pub-

lished more than a half a century ago.1 Markowitz provided a frameworkfor the selection of securities for portfolio construction to obtain an opti-mal portfolio. To do so, Markowitz suggested that for all assets that arecandidates for inclusion in a portfolio, one should measure an asset’s returnby its mean return and risk by an asset’s variance of returns. In the selec-tion of assets to include in a portfolio, the Markowitz framework takes intoaccount the co-movement of asset returns by using the covariance betweenall pairs of assets. The portfolio’s expected return and risk as measuredby the portfolio variance are then determined by the weights of each assetincluded in the portfolio. For this reason, the Markowitz framework is com-monly referred to as mean-variance portfolio analysis. Markowitz arguedthat the optimal portfolio should be selected based on the trade-off betweena portfolio’s return and risk. While these concepts are considered the basisof portfolio construction these days, the development of the mean-variancemodel shaped how investment managers analyze portfolios and sparked anoverwhelming volume of research on the theory of portfolio selection.

Once the fundamentals of modern portfolio theory were established,studies addressing the limitations of mean-variance analysis appeared,seeking to improve the effectiveness of the original model under practicalsituations. Some research efforts concentrated on reducing the sensitivity ofportfolios formed from mean-variance analysis. Portfolio sensitivity meansthat the resulting portfolio constructed using mean-variance analysis and itsperformance is heavily dependent on the inputs of the model. Hence, if theestimated input values were even slightly different from their true values,the estimated optimal portfolio will actually be far from the best choice.This is especially a drawback when managing equity portfolios because theequity market is one of the more volatile markets, making it difficult toestimate values such as expected returns.

In equity portfolio management, there has been increased interestin the construction of portfolios that offer the potential for more robustperformance even during more volatile equity market periods. One common

1