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Novel approaches for portfolio construction using second order stochastic dominance

Cristiano Arbex Valle (), Diana Roman () and Gautam Mitra ()
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Cristiano Arbex Valle: Optirisk Systems
Diana Roman: Brunel University
Gautam Mitra: Optirisk Systems

Computational Management Science, 2017, vol. 14, issue 2, No 5, 257-280

Abstract: Abstract In the last decade, a few models of portfolio construction have been proposed which apply second order stochastic dominance (SSD) as a choice criterion. SSD approach requires the use of a reference distribution which acts as a benchmark. The return distribution of the computed portfolio dominates the benchmark by the SSD criterion. The benchmark distribution naturally plays an important role since different benchmarks lead to very different portfolio solutions. In this paper we describe a novel concept of reshaping the benchmark distribution with a view to obtaining portfolio solutions which have enhanced return distributions. The return distribution of the constructed portfolio is considered enhanced if the left tail is improved, the downside risk is reduced and the standard deviation remains within a specified range. We extend this approach from long only to long-short strategies which are used by many hedge fund and quant fund practitioners. We present computational results which illustrate (1) how this approach leads to superior portfolio performance (2) how significantly better performance is achieved for portfolios that include shorting of assets.

Keywords: Portfolio optimisation; Stochastic dominance; Reference distribution; Left tail; Downside risk (search for similar items in EconPapers)
Date: 2017
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DOI: 10.1007/s10287-017-0274-9

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