27 Pages Posted: 15 Feb 2008
Date Written: 2007-05
Current research suggests that the large downside risk in hedge fund returns disqualifies the variance as an appropriate risk measure. For example, one can easily construct portfolios with nonlinear pay-offs that have both a high Sharpe ratio and a high downside risk. This paper examines the consequences of shortfall-based risk measures in the context of portfolio optimization. In contrast to popular belief, we show that negative skewness for optimal mean-shortfall portfolios can be much greater than for mean-variance portfolios. Using empirical hedge fund return data we show that the optimal mean-shortfall portfolio substantially reduces the probability of small shortfalls at the expense of an increased extreme crash probability. We explain this by proving analytically under what conditions short-put payoffs are optimal for a mean-shortfall investor. Finally, we show that quadratic shortfall or semi-variance is less prone to these problems. This suggests that the precise choice of the downside risk measure is highly relevant for optimal portfolio construction under loss averse preferences.
Suggested Citation: Suggested Citation
Lucas, Andre and Siegmann, Arjen, The Effect of Shortfall as a Risk Measure for Portfolios with Hedge Funds (2007-05). Journal of Business Finance & Accounting, Vol. 35, Issue 1-2, pp. 200-226, January/March 2008. Available at SSRN: https://ssrn.com/abstract=1091590 or http://dx.doi.org/10.1111/j.1468-5957.2007.02054.x
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