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Why Distributions Matter

By Peter Urbani 16 Jan 2012

Why Distributions Matter


My ventures are not in one bottom trusted, Nor to one place; nor is my whole estate Upon the fortune of this present year; Therefore, my merchandise makes me not sad.
Spoken by Antonio in Act I, Scene I, Merchant of Venice, William Shakespeare, circa 1650
Rembrandts Christ in the storm on the lake of Galilee the cover illustration of Peter Bernsteins excellent Against the Gods The Remarkable Story of Risk

Diversification
Diversification is the key principle upon which Modern Portfolio Theory (MPT) is built - although the concept of not putting all of ones eggs into one basket dates all the way back to biblical times. Central to this is the concept of Correlation as measure of dependence between assets

Key Assumptions
Correlation ( the standardised covariance between assets ) as the measure of dependence between assets

Normally distributed returns. The assumption that asset returns are normally distributed about their means.

The Problem with Assumptions

They make an ASS out of U and ME

Normality Testing

Normality Testing

ETF's

Hedge Funds

Normal Not-Normal

Normal Not-Normal

Assumed Normal
Assumed Normal
Assumed Normal Fund PDF (Normal)

Normal VaR

Normal CVaR

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

If not Normal then What ? - Modified

VaR ( Modified ) lower for small positive skew

Cornish Fisher - Modification

VaR ( Modified ) higher for small negative skew

Cornish Fisher - Modification

VaR ( Modified ) same as VaR ( Normal ) for no skew

Assumed Normal
Assumed Normal
Assumed Normal Fund PDF (Normal)

Normal VaR

Normal CVaR

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

Assumed Modified
Assumed Normal and Modified Distributions
Assumed Normal Fund PDF (Normal)

Assumed Modified Normal Fund PDF (Modified)

Normal VaR

Normal CVaR Modified VaR Modified CVaR -

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

Cornish Fisher - Modification


1.3.2 Properties
The qualitative properties of the Cornish-Fisher expansion are:

If is a sequence of distributions converging to the standard normal distribution , the Edgeworth- and Cornish-Fisher approximations present better approximations (asymptotically for ) than the normal approximation itself. The approximated functions and are not necessarily monotone. -quantiles becomes less and less reliable

has the ``wrong tail behavior'', i.e., the Cornish-Fisher approximation for for (or ).

The Edgeworth- and Cornish-Fisher approximations do not necessarily improve (converge) for a fixed order of approximation, .

and increasing

For more on the qualitative properties of the Cornish-Fisher approximation see (Jaschke; 2001). It contains also an empirical analysis of the error of the Cornish-Fisher approximation to the 99%-VaR in real-world examples as well as its worst-case error on a certain class of one- and two-dimensional delta-gamma-normal models:
http://fedc.wiwi.hu-berlin.de/xplore/tutorials/xfghtmlnode8.html

Problems with Modified VaR Not Monotone


Modified VaR as a function of Skewness
-10.00% Modified VaR @ CL 99.00% Modified VaR @ CL 95.00% Current Current

-5.00%

0.00%

VaR ( Modified )

5.00%

10.00%

15.00%

20.00% -6 -4 -2 0 Skewness 2 4 6

http://discussions.ft.com/alchemy/forums/edhec-risk-forum/hedge-fund-risk-management-models-for-the-return-distribution/

Problems with Modified VaR Bad Tail Behaviour


100.00%
Modified CDF

90.00%
Normal CDF

18

80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% -0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4

Kurt

S
12

Good Z Z

2500.00% Modified PDF Normal PDF 2000.00%

0
1500.00%

Skew

1000.00%

500.00%

-6
0.00% -30.0%

Z
-6 -4 -2 0 2 4 6

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

Problems with Modified VaR Bad Tail Behaviour


100.00%
Modified CDF

90.00%
Normal CDF

18

80.00% 70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% -0.5 -0.4 -0.3 -0.2 -0.1 0 0.1 0.2 0.3 0.4

Kurt

S
12

Good Z Z

2500.00% Modified PDF Normal PDF 2000.00%

0
1500.00%

Skew

1000.00%

500.00%

-6
0.00% -30.0%

Z
-6 -4 -2 0 2 4 6

-20.0%

-10.0%

0.0%

10.0%

20.0%

30.0%

How Prevalent is this problem ?


VERY
ETF's
Hedge Funds

OK

OK

WARNING: Degenerate Cornish Fisher. CDF w ill turn in tails WARNING: Degenerate Cornish Fisher. CDF w ill turn in body

WARNING: Degenerate Cornish Fisher. CDF w ill turn in tails WARNING: Degenerate Cornish Fisher. CDF w ill turn in body

VBA code to check Cornish Fisher - Modification


Public Function CFRegionWarning(ByVal Skew As Double, Kurt As Double) As String Dim a As Double Dim b As Double Dim c As Double Dim Q As Double Dim R As Double Dim Denom As Double Denom = 3 * Kurt - 4 * (Skew ^ 2) If Denom > 0 Then a = 12 * Skew / Denom b = (10 * Skew ^ 2 - 9 * Kurt + 72) / Denom c = -12 * Skew / Denom Q = (a ^ 2 - 3 * b) / 9 R = (2 * (a ^ 3) - 9 * a * b + 27 * c) / 54 If R ^ 2 > Q ^ 3 Then CFRegionWarning = "" 'Its in Well Behaved Region Else CFRegionWarning = "WARNING: Degenerate Cornish Fisher. CDF will turn in body (S)" End If Else CFRegionWarning = "WARNING: Degenerate Cornish Fisher. CDF will turn in tails (Z)" End If End Function

If not Normal or Modified then What ?


Best Fitting Distributions
ETF's
Hedge Funds

Gumbel (Max) 7.8% Gumbel (Min) 8.2% Johnson (Lognormal) 13.5% Johnson (Unbounded) 0.6% Mixture of Normals 20.1% Modified Normal 35.8% Normal 12.9% Uniform 1.0%

Gumbel (Max) 23.3% Gumbel (Min) 13.2% Johnson (Lognormal) 13.2% Johnson (Unbounded) 2.6% Mixture of Normals 15.9% Modified Normal 21.2% Normal 6.9% Uniform 3.7%

Assumed Normal
Assumed Normal
Assumed Normal Fund PDF (Normal)

Normal VaR

Normal CVaR

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

Assumed Modified
Assumed Normal and Modified Distributions
Assumed Normal Fund PDF (Normal)

Assumed Modified Normal Fund PDF (Modified)

Normal VaR

Normal CVaR Modified VaR Modified CVaR -

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

Best Fitting
Best Fit and Assumed Normal and Modified Distributions
Best Fit Fund PDF (Gumbel (Min)) Assumed Normal Fund PDF (Normal) Assumed Modified Normal Fund PDF (Modified)

Best Fit VaR Normal VaR Best Fit CVaR Normal CVaR Modified VaR Modified CVaR -

-40.00%

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

40.00%

Goodness of Fit
Cummulative Probability Distributions
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% -20% 0% -40.00% -30.00% -20.00% -10.00% 0.00% 10.00% 20.00% 30.00% 40.00% -25% 0% -25% -5% -10% -15% 20%

P-P Plot (Showing Goodness of Fit for Fund)

Best Fit Fund CDF (Gumbel (Min)) Assumed Normal Fund CDF (Normal) Empirical CDF Fund

Series1 15% 10% 5% Fund Best Fit (Gumbel (Min)) Fund Assumed (Normal)

-20%

-15%

-10%

-5%

0%

5%

10%

15%

Relationship Between Assets

Relationship between Fund A and B


10.00% 8.00%

6.00%

4.00%

FUND A

Linear Regression 2.00%

0.00%

-2.00%

-4.00% -6.00% -4.00% -2.00% 0.00% 2.00% FUND B 4.00% 6.00% 8.00% 10.00%

Assumed Bi-Variate Normal Copula


10.00% 8.00%

6.00%

4.00%

Assumed Bi-variate Normal Copula Lines

FUND A
2.00%

Linear Regression

0.00%

-2.00%

-4.00% -6.00% -4.00% -2.00% 0.00% 2.00% FUND B 4.00% 6.00% 8.00% 10.00%

Best Fit Bi-Variate Copula


10.00% Best Fit Bi-variate Copula Lines 8.00% Best Fit Regression

6.00%

Linear Regression

4.00%

FUND A
2.00% 0.00% -2.00% -4.00% -6.00% -4.00% -2.00% 0.00% 2.00% FUND B 4.00% 6.00% 8.00% 10.00%

Example Johnson Lognormal - Normal


50.00% Best Fit Bi-variate Copula Lines 40.00% Best Fit Regression

30.00%

Linear Regression

20.00%

FUND C
10.00% 0.00% -10.00% -20.00% -8.00% -6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% FUND D

Example Normal - Normal


15.00% Best Fit Bi-variate Copula Lines 10.00% Best Fit Regression

Linear Regression 5.00%

FUND E

0.00%

-5.00%

-10.00%

-15.00% -6.00% -4.00% -2.00% 0.00% FUND F 2.00% 4.00% 6.00% 8.00%

Example Modified Normal - Normal


8.00% Best Fit Bi-variate Copula Lines 6.00% Best Fit Regression

Linear Regression 4.00%

FUND G

2.00%

0.00%

-2.00%

-4.00% -15.00% -10.00% -5.00% 0.00% FUND H 5.00% 10.00% 15.00%

Example Mix Normals Modified Normal


30.00% Best Fit Bi-variate Copula Lines 20.00% Best Fit Regression

10.00%

Linear Regression

0.00%

FUND I
-10.00% -20.00% -30.00% -40.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% FUND J 10.00% 15.00% 20.00% 25.00% 30.00%

Example Mod Normal Mod Normal


40.00% Best Fit Bi-variate Copula Lines 30.00% Best Fit Regression 20.00% Linear Regression 10.00%

FUND K

0.00%

-10.00%

-20.00%

-30.00%

-40.00% -50.00% -40.00% -30.00% -20.00% -10.00% 0.00% FUND L 10.00% 20.00% 30.00% 40.00% 50.00%

Relationship Between Assets


2011 Asset Class Correlations
40.00% 30.00% 20.00%
Total Returns ( % )

10.00% 0.00% -10.00% -20.00% -30.00% -40.00% -1.00

-0.50

0.00
Correlation to S&P500

0.50

1.00

Relationship Between Assets


2011 Asset Class Correlations
20.00% 15.00% 10.00%
Total Returns ( % )
US Government Bonds

US Total Bond Market

Gold US Bonds Cash US High Yield Bonds Global Bond Index US Real Estate

5.00% 0.00%
US Dollar CTA's

Emerging Markets Bonds US Equities Oil Hedge Funds

International Government Bonds

-5.00% -10.00% -15.00%

Volatility

World Equities

Emerging Market Equities

-20.00% -1.00

-0.50

0.00
Correlation to S&P500

0.50

1.00

Correlations at multi-decade highs

Best Fit and Pearson Correl Pairs with CAGR > 7%


Base Fund
Lowest Correlation via Best Fit Lowest Correlation via Pearson Correl

30.00%

30.00%

Best Fit Pair CORN - OLO


20.00% 10.00%

Best Fit Bi-variate Copula Lines 20.00% Best Fit Regression

Pearson Pair CORN - USO


10.00%

Best Fit Bi-variate Copula Lines

Best Fit Regression

Linear Regression

Linear Regression

0.00%

0.00%

Corn Fund

-10.00%

Corn Fund
-10.00% -20.00% -20.00% -30.00% -30.00% -40.00% -25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% DB Crude Oil Long ETN -40.00% -25.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% United States Oil Fund

12.00%

12.00%

10.00%

Best Fit Pair VQT - UCC

Best Fit Bi-variate Copula Lines 10.00% Best Fit Regression

Pearson Pair VQT - EEH

Best Fit Bi-variate Copula Lines

Best Fit Regression 8.00%

8.00%

Linear Regression 6.00% 6.00%

Linear Regression

Barclays ETN+ S&P VEQTOR ETN

4.00%

Barclays ETN+ S&P VEQTOR ETN


-10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% 25.00% 30.00% 35.00%

4.00%

2.00%

2.00%

0.00%

0.00%

-2.00%

-2.00%

-4.00%

-4.00%

-6.00% -15.00% Ultra Consumer Services

-6.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% SPECTRUM Lg Cap U.S. Sector ETN

25.00%

25.00%

Best Fit Pair DLBL - HYG


20.00% 15.00%

Best Fit Bi-variate Copula Lines 20.00% Best Fit Regression

Pearson Pair DLBL - JNK


15.00%

Best Fit Bi-variate Copula Lines

Best Fit Regression

Linear Regression

Linear Regression

US Treasury Long Bond Bull ETN

10.00%

US Treasury Long Bond Bull ETN


-6.00% -4.00% -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% 12.00%

10.00%

5.00%

5.00%

0.00%

0.00%

-5.00%

-5.00%

-10.00% -8.00% iBoxx $ HY Corp Bond Fund

-10.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% SPDR Barclays Capital High Yield Bond ETF

40.00%

20.00%

Best Fit Pair WREI - FTY


30.00% 20.00%

Best Fit Bi-variate Copula Lines 15.00% Best Fit Regression

Pearson Pair WREI - RWO


10.00%

Best Fit Bi-variate Copula Lines

Best Fit Regression

Linear Regression

Linear Regression

Wilshire US REIT ETF

0.00%

Wilshire US REIT ETF


-10.00% -5.00% 0.00% 5.00% 10.00% 15.00%

10.00%

5.00%

0.00%

-10.00%

-5.00%

-20.00%

-10.00%

-30.00% -15.00% FTSE NAREIT Real Estate 50 Index Fund

-15.00% -20.00% -15.00% -10.00% -5.00% 0.00% 5.00% 10.00% 15.00% 20.00% SPDR DJ Wilshire Global Real Estate ETF

Other Measures of Dependence


Spearmans Rank Order Correlation
Lins Concordance measure Copula methods Distance measures Mutual Information and other entropy based measures

Conclusions
Distributions do differ from Normal at least 15 20% of the time and up to 30 40% of the time depending on the data set being used Test them
The Cornish Fisher modification is not strictly monotone and should probably not be used at confidence levels above 95% The Cornish Fisher modification has poor tail behaviour almost half of the time CHECK Correlation is a limited and linear measure of dependence only Non-Linear Copula based methods offer significant promise in helping to find better diversification and pairs trading opportunities

Pietro (Peter) Urbani (45)


Chief Investment Officer (CIO) Infiniti Capital $3bn Fund of Hedge Funds Group Head of Quantitative Research Infiniti Capital CEO KnowRisk Consulting Asset Consulting Head of Investment Strategy Fairheads Asset Managers HNW Trust and Investment Boutique Head of Research Fairheads Asset Managers Head of Portfolio Management Nexus Securities

Senior Portfolio Manager Commercial Union Superfund


Equities Dealer Junior Portfolio Manager Mathison & Hollidge Stockbrokers

http://nz.linkedin.com/in/peterurbani

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