Do you have to be Abnormal to beat the Market ?

By Peter Urbani, CEO KnowRisk Consultin !

"n Mel Brooks#s $lassi$ %&'( $ome)y, *oun +rankenstein, the ran)son o, the ori inal Dr +rankenstein -./ene 0il)er1 )is2at$hes his ,aith,ul assistant " or .brilliantly 2laye) by Marty +el)man1 to steal a brain ,or his $reation ,rom a nearby laboratory3 "n his usual ,ashion " or bun les it an) brin s ba$k the wron brain3 0hen it be$omes a22arent that all is not well with the monster, Dr +rankenstein $on,ronts " or an) asks whose brain he has 4ust installe)3 " or#s res2onse 5Aby33somethin 333Aby-normal35 6he 2arallel to ,inan$e is that the assum2tion o, normality is )ee2ly in raine) in $lassi$al ,inan$e an) in 2arti$ular in the a22li$ation o, Mo)ern Port,olio 6heory .MP61 to 2ort,olio $onstru$tion in the ,orm o, Mean 7arian$e O2timisation .M7O13 "n this 2ro$ess the #o2timal# wei hts to hol) in ea$h se$urity or asset in your 2ort,olio are )etermine) base) on the Mean, avera e or e82e$te) return, an) the varian$e or more $ommonly the varian$e s9uare) or stan)ar) )eviation o, the overall 2ort,olio3 6he linkin o, return to #risk# throu h this ratio o, rewar) to variability was one o, the key insi hts o, :arry Markowit;#s seminal %&<= 2a2er on Port,olio >ele$tion an) was oo) enou h to earn him his Ph)3 an) eventually a ?obel Pri;e3 Althou h Markowit;#s theory )oes not re9uire returns to be normally )istribute) . /aussian or Bell >ha2e) 1, in 2ra$ti$e most 2eo2le still )o make that assum2tion3 Why does this matter to you ? 6he answer is sim2le3 0e now know that returns are not always ?ormally )istribute) about their means an) that thin s $an et i, not $om2letely abnormal at least a little skewe)3 @uite o,ten returns are skewe) either to the le,t .ne ative1 or ri ht .2ositive1 o, the $enter or mean an) $an also have e8$ess Kurtosis or 2eake)ness relative to the ?ormal )istribution3 >ometimes when they have both e8$ess 2eake)ness an) le,t skew they are sai) to be #le2tokurtoti$# whi$h soun)s like a ,orm o, le2orosy but is in ,a$t /reek ,or #6hin Ar$hes# an) )es$ribes the more 2eake) nature o, the )istribution3 6he

more $ommon re$ent term in +inan$e is +at 6aile) be$ause the $onse9uen$e o, the e8$ess 2eake)ness an) ne ative .le,t1 skewness is that both the ,re9uen$y .2robability1 an) ma nitu)e o, lar e losses is hi her than ?ormal un)er these $ir$umstan$es3 >o in a nutshell i norin these e,,e$ts by assumin ?ormality $an un)erestimate the 2otential ,or losses in your 2ort,olio3 >imilarly i norin 2ositive skewness $an un)erestimate the 2otential ,or one or more assets to out-2er,orm relative to the ?ormal )istribution3 A 2ort,olio $onstru$tion 2ro$ess that i nores these hi her moments . >kewness an) Kurtosis 1 will thus un)erwei ht or hol) less in that asset than it ar uably shoul)3 +ortunately there are now a number o, metho)s to take hi her moments or )i,,erently sha2e) return )istributions into $onsi)eration, however they are ,ar ,rom wi)ely use)3 6he sim2lest o, these metho)s is the so $alle) Mo)i,ie) )istribution metho) whi$h utilises a ,ormula )evelo2e) by E3A3Cornish in the %&=A#s known as the Cornish +isher e82ansion to take the im2a$t o, skewness an) e8$ess kurtosis into a$$ount3 0hen there is no skewness or e8$ess kurtosis these terms sim2ly $an$el out in the ,ormula whi$h then ives the same result as the ?ormal metho)3 Due to the relative $om2utational $om2le8ity o, these metho)s $om2uters have only really be$ome 2ower,ul enou h to utilise them in the 2ast )e$a)e or so3 6his is one reason ,or the slow u2take the other o, $ourse bein institutional inertia3 :owever there is no lon er really any e8$use ,or i norin these metho)s many o, whi$h $an now even be im2lemente) in a s2rea)sheet3 The key question here I guess is, is it worth the extra effort ? +ortunately as both metho)s . ?ormal an) Mo)i,ie) 1 are ,ully 9uantitative we $an run a horse ra$e between them by runnin them over the same )ata-set an) seein whi$h one )oes better on an out-o,-sam2le basis3 +or the 2ur2ose o, this e8er$ise " use) the un)erlyin se$tor E6+#s or "n)i$es ,or the >BP<AA, A>CDAA an) ?EC an) the 2er,orman$e is then $om2are) with that o, the "n)e8 whi$h stan)s in ,or the 2assive or buy an) hol) 2ort,olio3 6he o2timal wei hts in ea$h se$tor are )etermine) ,or the in-sam2le-2erio) o, the 2ast =F months3 0e then use those wei hts as the o2enin wei hts ,or the ne8t 2erio) an) re$or) the out-o,-sam2le 2er,orman$e base) on those wei hts ,or the the ne8t 2erio) be,ore re-balan$in ea$h 9uarter3 6his 2ro$ess is knows as a walk-,orwar) o2timisation an) is as $lose as we $an et to real worl) $on)itions a,ter the ,a$t3 0e re$or) the out-o,-sam2le $om2oun) avera e annual rowth rate . CA/R 1 ,or the "n)e8, 6he ?ormal an) Mo)i,ie) a22roa$hes ,or the %A years to en) De$ DA%=3 All in lo$al $urren$y terms3 "n)e8 >BP<AA A>CDAA ?EC<A G<3D%H G(3&FH GF3AFH ?ormal G'3D%H GF3<'H GI3%FH Mo)i,ie) G'3IIH GF3&&H GI3&'H

Althou h the )i,,eren$es between the ?ormal an) Mo)i,ie) results are relatively small it shoul) be borne in min) that retail investment 2ort,olio $osts are $urrently at aroun) A3'<H 2er annum an) institutional $osts aroun) A3(<H 2er annum or lower so even these mo)est im2rovements . $ause) by ,airly e,,i$ient E9uity markets bein ?ormal ,or mu$h o, the time 1 )o make a material )i,,eren$e to your terminal wealth3 6o 2ut that in a ?E $onte8t a A3FAH im2rovement in annual returns woul) translate into an e8tra J%<Am a year ,or someone like ?E >u2er whi$h is 9uite a lot more than their $urrent $osts3 "n a))ition, the Ma8imum Draw)own or lar est 2eak to trou h loss is enerally lowest ,or the Mo)i,ie) metho) alsoK "n)e8 >BP<AA A>CDAA ?EC<A -<D3<FH -<A3(IH -(%3='H ?ormal -<=3D=H -=&3A(H -=F3D<H Mo)i,ie) -<A3<FH -='3D%H -=F3A%H

>o now you know the answer to the 9uestion - Do you have to be Abnormal to beat the Market ? 6he Answer isL o, but it hel!s to "ontain "osts if you do "onsider the abnormality of returns# ! Peter Urbani is an e82ert in Risk Mana ement, Port,olio Constru$tion an) E8ternal Mana er sele$tion metho)s3 A basi$ s2rea)sheet )emonstration o, the metho)s )es$ribe) above $an be )ownloa)e) ,rom here . >ele$t Downloa) 38ls +ile 13