Portfolio Optimization for VAR, CVaR, Omega and Utility with General Return Distributions: A Monte Carlo Approach for Long-Only and Bounded Short Portfolios with Optional Robustness and a Simplified Approach to Covariance Matching

Abstract

We develop the idea of using Monte Carlo sampling of random portfolios to solve portfolio investment problems. We explore the need for more general optimization tools, and consider the means by which constrained random portfolios may be generated. DeVroye's approach to sampling the interior of a simplex (a collection of non-negative random variables adding to unity) is already available for interior solutions of simple fully-invested long-only systems, and we extend this to treat, lower bound constraints, bounded short positions and to sample non-interior points by the method of Face-Edge-Vertex-biased sampling. A practical scheme for long-only and bounded short problems is developed and tested. Non-convex and disconnected regions can be treated by applying rejection for other constraints. The advantage of Monte Carlo methods is that they may be extended to risk functions that are more complicated functions of the return distribution, without explicit gradients, and that the underlying return distribution may be modeled parametrically or empirically based on general distributions. The optimization of expected utility, Omega, Sortino ratios may be handled in a similar manner to quadratic risk, VaR and CVaR, irrespective of whether a reduction to LP or QP form is available. Robustification is also possible, and a Monte Carlo approach allows the possibility of relaxing the general maxi-min approach to one of varying degrees of conservatism. Grid computing technology is an excellent platform for the development of such computations due to the intrinsically parallel nature of the computation. Good comparisons with established results in Mean-Variance and CVaR optimization are obtained, and we give some applications to Omega and expected Utility optimization. Extensions to deploy Sobol and Niederreiter quasi-random methods for random weights are also proposed. Extensions to the value functions of prospect theory are possible. The initial method proposed here is essentially an initial global search which produces a good feasible solution for any number of assets with any risk function and return distribution. This solution is close to optimal in lower dimensions. A by-product of these investigations is a simplified approach - the "double-Cholesky method" - to sampling certain multivariate distributions matching the covariance matrix as well as the mean vector.

Keywords: portfolio, optimization, optimisation, random portfolio, Monte Carlo, simplex, VaR, CVaR, QP, mean-variance, non-gaussian, utility, expected utility, variability ratio, omega, sortino ratio, sharpe ratio, matching covariance, quasi-random, Sobol, Niederreiter

JEL Classification: C61, C63, G11