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Post-modern portfolio theory

Post-modern portfolio theory[1] (or PMPT) is an extension of the traditional modern portfolio
theory (MPT, which is an application of mean-variance analysis or MVA). Both theories propose how
rational investors should use diversification to optimize their portfolios, and how a risky asset should
be priced.

Contents
History
Overview
Tools
Downside risk
Sortino ratio
Volatility skewness
See also
Endnotes
References

History
The term post-modern portfolio theory was created in 1991 by software entrepreneurs Brian M. Rom
and Kathleen Ferguson to differentiate the portfolio-construction software developed by their
company, Investment Technologies, from those provided by the traditional modern portfolio theory.
It first appeared in the literature in 1993 in an article by Rom and Ferguson in The Journal of
Performance Measurement. It combines the theoretical research of many authors and has expanded
over several decades as academics at universities in many countries tested these theories to
determine whether or not they had merit. The essential difference between PMPT and the modern
portfolio theory of Markowitz and Sharpe (MPT) is that PMPT focuses on the return that must be
earned on the assets in a portfolio in order to meet some future payout. This internal rate of return
(IRR) is the link between assets and liabilities. PMPT measures risk and reward relative to this IRR
while MPT ignores this IRR and measures risk as dispersion about the mean or average return. The
result is substantially different portfolio constructions.

Empirical investigations began in 1981 at the Pension Research Institute (PRI) at San Francisco State
University. Dr. Hal Forsey and Dr. Frank Sortino were trying to apply Peter Fishburn's theory
published in 1977 to Pension Fund Management. The result was an asset allocation model that PRI
licensed Brian Rom to market in 1988. Mr. Rom coined the term PMPT and began using it to market
portfolio optimization and performance measurement software developed by his company. These
systems were built on the PRI downside risk algorithms. Sortino and Steven Satchell at Cambridge
University co-authored the first book on PMPT. This was intended as a graduate seminar text in
portfolio management. A more recent book by Sortino was written for practitioners. The first
publication in a major journal was co-authored by Sortino and Dr. Robert van der Meer, then at Shell
Oil Netherlands. The concept was popularized by numerous articles by Sortino in Pensions and
Investments magazine and Dr. Sortino's Blog: www.pmpt.me.

Sortino claims the major contributors to the underlying theory are:

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Peter Fishburn at the University of Pennsylvania who developed the mathematical equations for
calculating downside risk and provided proofs that the Markowitz model was a subset of a richer
framework.
Atchison & Brown at Cambridge University who developed the three parameter lognormal
distribution which was a more robust model of the pattern of returns than the bell shaped
distribution of MPT.
Bradley Efron, Stanford University, who developed the bootstrap procedure for better describing
the nature of uncertainty in financial markets.
William Sharpe at Stanford University who developed returns-based style analysis that allowed
more accurate estimates of risk and return.
Daniel Kahneman at Princeton & Amos Tversky at Stanford who pioneered the field of behavioral
finance which contests many of the findings of MPT.

Overview
Harry Markowitz laid the foundations of MPT, the greatest contribution of which is the establishment
of a formal risk/return framework for investment decision-making; see Markowitz model. By
defining investment risk in quantitative terms, Markowitz gave investors a mathematical approach to
asset-selection and portfolio management. But there are important limitations to the original MPT
formulation.

Two major limitations of MPT are its assumptions that:

1. the variance[2] of portfolio returns is the correct measure of investment risk, and
2. the investment returns of all securities and portfolios can be adequately represented by a joint
elliptical distribution, such as the normal distribution.

Stated another way, MPT is limited by measures of risk and return that do not always represent the
realities of the investment markets.

The assumption of a normal distribution is a major practical limitation, because it is symmetrical.

Using the variance (or its square root, the standard deviation) implies that uncertainty about better-
than-expected returns is equally averred as uncertainty about returns that are worse than expected.
Furthermore, using the normal distribution to model the pattern of investment returns makes
investment results with more upside than downside returns appear more risky than they really are.
The converse distortion applies to distributions with a predominance of downside returns. The result
is that using traditional MPT techniques for measuring investment portfolio construction and
evaluation frequently does not accurately model investment reality.

It has long been recognized that investors typically do not view as risky those returns above the
minimum they must earn in order to achieve their investment objectives. They believe that risk has to
do with the bad outcomes (i.e., returns below a required target), not the good outcomes (i.e., returns
in excess of the target) and that losses weigh more heavily than gains. This view has been noted by
researchers in finance, economics and psychology, including Sharpe (1964). "Under certain
conditions the MVA can be shown to lead to unsatisfactory predictions of (investor) behavior.
Markowitz suggests that a model based on the semivariance would be preferable; in light of the
formidable computational problems, however, he bases his (MV) analysis on the mean and the
standard deviation.[3]"

Recent advances in portfolio and financial theory, coupled with increased computing power, have
overcome these limitations. The resulting expanded risk/return paradigm is known as Post-Modern
Portfolio Theory, or PMPT. Thus, MPT becomes nothing more than a special (symmetrical) case of
PMPT.

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Tools
In 1987, the Pension Research Institute at San Francisco State University developed the practical
mathematical algorithms of PMPT that are in use today. These methods provide a framework that
recognizes investors' preferences for upside over downside volatility. At the same time, a more robust
model for the pattern of investment returns, the three-parameter lognormal distribution,[4] was
introduced.

Downside risk

Downside risk (DR) is measured by target semi-deviation (the square root of target semivariance)
and is termed downside deviation. It is expressed in percentages and therefore allows for rankings in
the same way as standard deviation.

An intuitive way to view downside risk is the annualized standard deviation of returns below the
target. Another is the square root of the probability-weighted squared below-target returns. The
squaring of the below-target returns has the effect of penalizing failures quadratically. This is
consistent with observations made on the behavior of individual decision-making under

where

d = downside deviation (commonly known in the financial community as 'downside risk'). Note: By
extension, d² = downside variance.

t = the annual target return, originally termed the minimum acceptable return, or MAR.

r = the random variable representing the return for the distribution of annual returns f(r),

f(r) = the distribution for the annual returns, e.g. the three-parameter lognormal distribution

For the reasons provided below, this continuous formula is preferred over a simpler discrete version
that determines the standard deviation of below-target periodic returns taken from the return series.

1. The continuous form permits all subsequent calculations to be made using annual returns which is
the natural way for investors to specify their investment goals. The discrete form requires monthly
returns for there to be sufficient data points to make a meaningful calculation, which in turn requires
converting the annual target into a monthly target. This significantly affects the amount of risk that is
identified. For example, a goal of earning 1% in every month of one year results in a greater risk than
the seemingly equivalent goal of earning 12% in one year.

2. A second reason for strongly preferring the continuous form to the discrete form has been
proposed by Sortino & Forsey (1996):

"Before we make an investment, we don't know what the outcome will be... After the
investment is made, and we want to measure its performance, all we know is what the
outcome was, not what it could have been. To cope with this uncertainty, we assume that
a reasonable estimate of the range of possible returns, as well as the probabilities
associated with estimation of those returns...In statistical terms, the shape of [this]
uncertainty is called a probability distribution. In other words, looking at just the discrete
monthly or annual values does not tell the whole story."
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Using the observed points to create a distribution is a staple of conventional performance

measurement. For example, monthly returns are used to calculate a fund's mean and standard
deviation. Using these values and the properties of the normal distribution, we can make statements
such as the likelihood of losing money (even though no negative returns may actually have been
observed), or the range within which two-thirds of all returns lies (even though the specific returns
identifying this range have not necessarily occurred). Our ability to make these statements comes
from the process of assuming the continuous form of the normal distribution and certain of its well-
known properties.

In PMPT an analogous process is followed:

1. Observe the monthly returns,

2. Fit a distribution that permits asymmetry to the observations,
3. Annualize the monthly returns, making sure the shape characteristics of the distribution are
retained,
4. Apply integral calculus to the resultant distribution to calculate the appropriate statistics.

Sortino ratio

The Sortino ratio, developed by Rom's company, Investment Technologies, was the first new element
in the PMPT rubric. It was designed to replace MPT's Sharpe ratio as a measure of risk-adjusted
return. It is defined as:

where

r = the annualized rate of return,

t = the target return,

d = downside risk.

The following table shows that this ratio is demonstrably superior to the traditional Sharpe ratio as a
means for ranking investment results. The table shows risk-adjusted ratios for several major indexes
using both Sortino and Sharpe ratios. The data cover the five years 1992-1996 and are based on
monthly total returns. The Sortino ratio is calculated against a 9.0% target.

Index Sortino ratio Sharpe ratio

90-day T-bill -1.00 0.00
Lehman Aggregate -0.29 0.63
MSCI EAFE -0.05 0.30
Russell 2000 0.55 0.93
S&P 500 0.84 1.25

As an example of the different conclusions that can be drawn using these two ratios, notice how the
Lehman Aggregate and MSCI EAFE compare - the Lehman ranks higher using the Sharpe ratio
whereas EAFE ranks higher using the Sortino ratio. In many cases, manager or index rankings will be

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different, depending on the risk-adjusted measure used. These patterns will change again for
different values of t. For example, when t is close to the risk-free rate, the Sortino Ratio for T-Bill's
will be higher than that for the S&P 500, while the Sharpe ratio remains unchanged.

In March 2008, researchers at the Queensland Investment Corporation and Queensland University
of Technology showed that for skewed return distributions, the Sortino ratio is superior to the Sharpe
ratio as a measure of portfolio risk.[5]

Volatility skewness

Volatility skewness is the second portfolio-analysis statistic introduced by Rom and Ferguson under
the PMPT rubric. It measures the ratio of a distribution's percentage of total variance from returns
above the mean, to the percentage of the distribution's total variance from returns below the mean.
Thus, if a distribution is symmetrical ( as in the normal case, as is assumed under MPT), it has a
volatility skewness of 1.00. Values greater than 1.00 indicate positive skewness; values less than 1.00
indicate negative skewness. While closely correlated with the traditional statistical measure of
skewness (viz., the third moment of a distribution), the authors of PMPT argue that their volatility
skewness measure has the advantage of being intuitively more understandable to non-statisticians
who are the primary practical users of these tools.

The importance of skewness lies in the fact that the more non-normal (i.e., skewed) a return series is,
the more its true risk will be distorted by traditional MPT measures such as the Sharpe ratio. Thus,
with the recent advent of hedging and derivative strategies, which are asymmetrical by design, MPT
measures are essentially useless, while PMPT is able to capture significantly more of the true
information contained in the returns under consideration. Many of the common market indices and
the returns of stock and bond mutual funds cannot themselves always be assumed to be accurately
represented by the normal distribution.

Index Upside Volatility(%) Downside Volatility(%) Volatility skewness

Lehman Aggregate 32.35 67.65 0.48
Russell 2000 37.19 62.81 0.59
S&P 500 38.63 61.37 0.63
90-day T-Bill 48.26 51.74 0.93
MSCI EAFE 54.67 45.33 1.21

Data: Monthly returns, January, 1991 through December, 1996.

See also
Outline of finance § Post-modern portfolio theory

Endnotes
1. The earliest citation of the term 'Post-Modern Portfolio Theory' in the literature appears in the
article "Post-Modern Portfolio Theory Comes of Age" by Brian M. Rom and Kathleen W.
Ferguson, published in The Journal of Investing, Winter, 1993. Summarized versions of this
article have been subsequently published in a number of other journals and websites.
2. In MPT, the terms variance, variability, volatility and standard deviation are used interchangeably
to represent investment risk.
3. See Sharpe [1964]. Markowitz recognized these limitations and proposed downside risk (which
he called "semivariance") as the preferred measure of investment risk. The complex calculations
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and the limited computational resources at his disposal, however, made practical implementations
of downside risk impossible. He therefore compromised and stayed with variance.
4. The three-parameter lognormal distribution is the only pdf that has thus far been developed for
robust solutions of downside risk calculations permits both positive and negative skewness in
return distributions. This is a more robust measure of portfolio returns than the normal
distribution, which requires that the upsides and downside tails of the distribution be identical.
5. Chaudhry, Ashraf; Johnson, Helen (March 2008). "The Efficacy of the Sortino Ratio and Other
Benchmarked Performance Measures Under Skewed Return Distributions". Australian Journal of
Management. 32 (3): 485. doi:10.1177/031289620803200306 (https://doi.org/10.1177%2F031289
620803200306).

References
For a comprehensive survey of the early literature, see R. Libby and P.C. Fishburn [1977].

Bawa, V. S. (1982). "Stochastic Dominance: A Research Bibliography" (https://doi.org/10.1287%2

Fmnsc.28.6.698). Management Science. 28 (6): 698–712. doi:10.1287/mnsc.28.6.698 (https://doi.
org/10.1287%2Fmnsc.28.6.698).
Balzer, L. A. (1994). "Measuring Investment Risk: A Review". Journal of Investing. 3 (3): 47–58.
doi:10.3905/joi.3.3.47 (https://doi.org/10.3905%2Fjoi.3.3.47).
Clarkson, R.S. Presentation to the Faculty of Actuaries (British). February 20, 1989.
Fishburn, Peter C. (1977). "Mean-Risk Analysis with Risk Associated with Below-Target Returns".
American Economic Review. 67 (2): 116–126. JSTOR 1807225 (https://www.jstor.org/stable/1807
225).
Hammond, Dennis R. (1993). "Risk Management Approaches in Endowment Portfolios in the
1990s". Journal of Investing. 2 (2): 52–57. doi:10.3905/joi.2.2.52 (https://doi.org/10.3905%2Fjoi.2.
2.52).
Harlow, W.V. "Asset Allocation in a Downside Risk Framework." Financial Analysts Journal, Sept-
Oct 1991.
"Investment Review." Brinson Partners, Inc. 1992.
Kaplan, P. and L. Siegel. "Portfolio Theory is Alive and Well," Journal of Investing, Fall 1994.
Lewis, A.L. "Semivariance and the Performance of Portfolios with Options." Financial Analysts
Journal, July–August 1990.
Leibowitz, M.L. and S. Kogelman. "Asset Allocation under Shortfall Constraints." Salomon
Brothers, 1987.
Leibowitz, M.L., and T.C. Langeteig. "Shortfall Risks and the Asset Allocation Decision." Journal
of Portfolio management, Fall 1989.
Libby, R.; Fishburn, P.C. (1977). "Behavioral Models of Risk taking in Business decisions: A
Survey and Evaluation". Journal of Accounting Research. 15 (2): 272–292. doi:10.2307/2490353
(https://doi.org/10.2307%2F2490353). JSTOR 2490353 (https://www.jstor.org/stable/2490353).
See also Kahneman, D.; Tversky, A. (1979). "Prospect Theory: An Analysis of Decision under
Risk". Econometrica. 47 (2): 263–291. CiteSeerX 10.1.1.407.1910 (https://citeseerx.ist.psu.edu/vi
ewdoc/summary?doi=10.1.1.407.1910). doi:10.2307/1914185 (https://doi.org/10.2307%2F19141
85). JSTOR 1914185 (https://www.jstor.org/stable/1914185).
Post-Modern Portfolio Theory Spawns Post-Modern Optimizer." Money Management Letter,
February 15, 1993.
Rom, B. M. and K. Ferguson. "Post-Modern Portfolio Theory Comes of Age." Journal of Investing,
Winter 1993.
Rom, B. M. and K. Ferguson. "Portfolio Theory is Alive and Well: A Response." Journal of
Investing, Fall 1994.
Rom, B. M. and K. Ferguson. "A software developer's view: using Post-Modern Portfolio Theory
to improve investment performance measurement." Managing downside risk in financial markets:
Theory, practice and implementation; Butterworth-Heinemann Finance, 2001; p59.
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Sharpe, William F. (September 1964). "Capital Asset Prices: A Theory of Market Equilibrium
under Consideration of Risk" (http://hdl.handle.net/10.1111/j.1540-6261.1964.tb02865.x). Journal
of Finance. XIX (3): 425–442. doi:10.2307/2977928 (https://doi.org/10.2307%2F2977928).
hdl:10.1111/j.1540-6261.1964.tb02865.x (https://hdl.handle.net/10.1111%2Fj.1540-6261.1964.tb0
2865.x). JSTOR 2977928 (https://www.jstor.org/stable/2977928).
Sortino, F. "Looking only at return is risky, obscuring real goal." Pensions and Investments
magazine, November 25, 1997.
Sortino, F. and H. Forsey "On the Use and Misuse of Downside Risk." The Journal of Portfolio
Management, Winter 1996.
Sortino, F. and L. Price. "Performance Measurement in a Downside Risk Framework." Journal of
Investing, Fall 1994.
Sortino, F. and S. Satchell, editors. "Managing downside risk in financial markets: Theory, practice
and implementation" Butterworth-Heinemann Finance, 2001.
Sortino, F. and R. van der Meer. "Downside Risk: Capturing What's at Stake." Journal of Portfolio
Management, Summer 1991.
"Why Investors Make the Wrong Choices." Fortune Magazine, January 1987.
"The Sortino Framework for Constructing Portfolios," Elsevier Inc 2010.
"Downside Risk",The Journal of Portfolio Management 1991

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