Where is the Efficient Frontier?

The efficient frontier, representing the optimal trade-off between risk and return, is a highly valued tool for the construction and analysis of investment portfolios. No textbook on investment analysis will fail to plot the familiar parabola in the return/variance plane, or the hyperbola in the return/volatility plane. In theory, the approach is relatively straightforward and not very exciting if the relevant parameters of the return-distribution are known: the expected returns, the volatilities, and the correlations between the returns. There is plenty of software to work out the numerical details. It is another matter when the parameters are unknown and have to be estimated. The efficient frontier based on a sample of return data may yield a rather misleading picture with regard to the risk/return trade-off. This short contribution to Future will document this deplorable and somewhat familiar fact. We will also show that knowledge of the means is much more helpful in locating the efficient frontier than knowledge of the second order moments (volatilities and correlations). In addition, we will outline how a correct use of the bootstrap-method can help to locate the true efficient frontier more precisely, using only sample data. To fix ideas, consider the following investment opportunity set1: We have a risk-free asset with a fixed annualized return of 2.5%. There are three risky assets, called stocks, which are expected to return: [ 8% 9% 12%]

per annum respectively. Their volatilities are equal to: [15% 20% 22%] respectively. And the final input is the correlation-matrix of the returns:

+.5 1

+.7 -.2 1

Note that stocks 2 and 3 are negatively correlated and that they have the higher expected returns. Typically, a mean-variance efficient portfolio will take a long position in a combination of these two stocks, with a slight tilt towards stock 3, financed partly with a short position in the remaining low return/low volatility stock.
1

I have borrowed these numbers from D. Bertsimas et al, who wrote a must-read paper on Shortfall as a risk measure: properties, optimization and applications, Feb. 2001, Sloan School of Management, MIT 1

One buys essentially a hedge fund. (We will assume no short sale constraints). Investors with a sufficiently large risk-appetite will increase the leverage by borrowing against the risk-free rate. In general, the optimal weight vector x for the risky assets is proportional to: (the inverse of ) times ( minus the risk free rate) where is the covariance matrix of the returns and collects the expected values. The proportionality factor decreases when the risk/volatility aversion increases. In the limit, with zero tolerance for volatility, x equals zero and one invests in the risk free asset only. An example of an optimal x is: [-1.53 .96 1.08] So for every unit of equity one sells stock 1 short, raising 1.53, one invests .96 and 1.08 in stock 2 and 3 respectively, and the balance, .49 (the sum of the x-components equals .51) is put into the risk free account. The expected return is about 10.6% and the volatility is approximately 13.4%. If we vary across the whole range of risk-aversion, calculating the expected values and variances of the returns of optimal portfolios as we go along, we trace out the familiar parabola in the mean/variance plane. The green, lightly dotted line in the diagram below illustrates this.

The true efficient frontier is based on the correct values of the parameters of the return distribution. It seems fair to say that these values are in general unknown, and have to be guessed or estimated one way or the other. A very simple and popular approach is
2

to replace the theoretical values and by their sample equivalents based on a suitable sample of returns. As a rule of thumb, one typically collects 60 consecutive monthly returns on the assets and estimates by the sample average and by the sample covariance matrix. As a consequence, both the optimal weights and the efficient frontier are random, they vary with the sample. The sample frontier can deviate strongly from its correct location. This is exemplified in the diagram by the red, lightly dotted line, the top line, so to speak. This curve represents the average sample frontier, using normality of the returns as a working hypothesis. All efficient frontiers in the diagram, except the black curve, are exact; they are not based on simulations but exact calculations.2 As one can see, the estimated expected return and variance are grossly biased. The average sample curve is shifted upward and to the right relative to the correct position, witness in particular the dislocation of the upper right-hand point of the true frontier to the corresponding endpoint at the average frontier. It appears that the more aggressive one invests, the more one will tend to overestimate the expected return and variance. Perhaps it is a good idea to incorporate aversion to estimation risk into the portfolio optimization problem. The diagram also makes clear that attempts to improve the situation are best directed at the estimation of the expected values, , instead of at the covariance matrix : If we know , but have to estimate , we get on the average the red curve just below the top line. This is not much of an improvement. In the reverse case however, with known and unknown , we obtain on the average the green line slightly above the true efficient frontier, which is a major improvement. Unfortunately, as you would have guessed, the task of estimating the mean is very hard, much harder than estimating the covariance matrix. Therefore, it seems that we are stuck. Some have suggested using the bootstrap, a distribution-free all-purpose statistical tool, to get a more trustworthy result. A simple version, which I believe is even trade-marked (!), would work as follows: Treat the dataset at hand, a 60 by 3 matrix of consecutive monthly returns of the three stocks, as the true return distribution, and simulate the procedure for estimating the efficient frontier from this distribution. That is to say, we generate pseudo-histories by drawing with replacement 60 rows from the given return-matrix. We apply whatever method we use to estimate the frontier on each of the generated pseudo-data sets and average the results. The idea or rather the hope is that we get a more stable, useful result. Unfortunately, in this context it makes matters even worse. Whatever bias our procedure has, in our case the sample frontier tends to overestimate, it will be amplified by this implementation of the bootstrap. (The simulated curve, not shown, lies substantially above the average sample frontier!). Since the bootstrap happens to be my favorite statistical tool, this is unacceptable, and I propose to use it in the following way: For a given dataset, calculate the estimated expected return and variance of an efficient portfolio in the usual way. Then generate a large number of pseudo datasets of the same size, as before by random selection with replacement from the rows of the given matrix. Apply the same calculations to each of the pseudo-sets. Suppose that for the original data the expected return is estimated at 12%, whereas the average value across the pseudo-sets equals 16%, say. This means that the estimation procedure
A crucial piece of input for the calculations is the exact covariance matrix of the inverse of the sample covariance matrix. The author is indebted to Ton Steerneman, University of Groningen, for the derivation of this matrix. 3
2

tends to overestimate the true value by 4%. Consequently, the estimate of 12% is reduced to 8%( 12% minus the bias). We deal similarly with the variance, and obtain a bias-corrected estimate of the efficient frontier. The black curve in the diagram represents the average of a large number of simulations following the bias-correcting procedure as outlined. Clearly, on the average we have indeed done well. The center of the distribution of the estimated frontiers is much more in line with the true frontier. On the average, we know where the efficient frontier is. However, we are far from done! The sampling uncertainty is surprisingly large, even for the situation as reported where there are 60 observations from a stable distribution on just three stock returns. To stress the point, it can be shown that the standard deviations of the estimators for the optimal weights, the components of x as specified above, equal: [1.35 .75 .82]

So without knowledge of and , using sample data only, there is a real possibility that the hedge fund takes the wrong long/short positions. Incidentally, in case of normality the expected value of the classical weight estimator is (n-1)/(n-p-2) times the true value, here n is the number of observations and p is the number of stocks. Obviously, we have serious problems when the number of stocks is large relative to the number of observations! It is imperative to develop robust methods if one wants to continue to use the classical approach. Some attempts have been made in the literature using Stein rule estimation methods and Bayesian approaches3, but the issues are far from settled. Anyone? November 2001 Prof. Dr. Theo K. Dijkstra SNS Asset Management, SAM-research, s-Hertogenbosch University of Groningen, Department of Econometrics Theo.Dijkstra@sns.nl

See e.g. D.Prieul and R. Thompson: Overview of single-period asset allocation models, part 1, November 2000, Lehman Brothers, Fixed Income Research. Or: S. Satchell and A. Scowcroft: A demystification of the Black-Litterman model, 2000, Journal of Asset Management, volume 1, 138-150. 4