Research Note

Andreas Steiner Consulting GmbH

March 2011

Drawdown-At-Risk Monte
Carlo Optimization
Introduction
In this research note, we would like to present a portfolio construction approach with two
interesting features…

 The risk measure used is “drawdown-at-risk”, an interesting concept combining

attractive features of drawdown and value-at-risk measures.

 The efficient frontier is calculated from “random portfolios”, i.e. portfolios

containing random constituent weights. We call this “Monte Carlo optimization”.

Both features would deserve a detailed analysis that goes well beyond the scope of this
publication. The goal of this note is to provide an overview and illustrate the potential of
the approach with two examples:

 Asset allocation in a small universe consisting of three assets (Indian stocks and
bonds as well as gold in INR).

 Drawdown optimization on single-stock level across the full S&P 500 universe.

Drawdown-At-Risk
As discussed in a previous research note1, drawdown is defined as the difference
between the portfolio value and its running maximum. Maximum drawdown is the largest
drawdown. The chart below shows the daily running maximum and level for an Indian
stock market index between 1 August 1994 and 11 February 20112.

The 'BSE SENSEX' is a value-weighted index composed of the 30 largest and most
actively traded stocks, representative of various sectors, on the Bombay Stock
Exchange. The index covers around fifty per cent of the market capitalization of the

1
Research Note December 2010, “Ambiguity in Calculating and Interpreting Maximum Drawdown”, available on
http://www.andreassteiner.net/consulting
2
We would like to thank India Life Capital Pvt. Ltd for providing data.

© 2011, Andreas Steiner Consulting GmbH. All rights reserved. 1 / 12

Electronic copy available at: http://ssrn.com/abstract=1782664

BSE. The Sensex is generally regarded as the pulse of the domestic stock markets in
India.

25'000

20'000
BSE SENSEX Closing Value
Running Maximum
15'000

10'000

5'000

The next chart is also known as the “underwater chart” and plots the (percentage)
difference between the running maximum and the index level…

0.0%

-10.0%

-20.0%

-30.0%

-40.0%

-50.0%

-60.0%

-70.0%

We can read off the maximum drawdown from this chart. Maximum drawdown was
60.91% and occurred during the recent Financial Crisis. Recovery is almost completed
by February 2011.

The underwater chart can also be used to derive the empirical distribution of all
drawdowns by simply sorting them by size. We have done this in the chart below, which

© 2011, Andreas Steiner Consulting GmbH. All rights reserved. 2 / 12

Electronic copy available at: http://ssrn.com/abstract=1782664

also plots the sorted drawdowns of the total returns of an Indian bond index I-BEX TRI
and the gold price3 expressed in Indian Rupee.

I-BEX TRI is a family of bond indices that act as a metric to measure the performance of
the government securities market. The aggregate index used here is a market-cap
weight total return index containing liquid securities (securities not traded in market lots
in at least three consecutive days are dropped). Launched in 1994, it has emerged as
the preferred Indian government benchmark and is also recommended by the
Association of Mutual Funds in India (AMFI).

0.0%

-10.0%

-20.0%

-30.0%
BSE SENSEX Closing Value

I-BEX TRI
-40.0%
Gold INR

-50.0%

-60.0%

-70.0%

The maximum drawdown is the rightmost value in the chart above, where the drawdown
curve hits the y axis.

We can see that the maximum drawdown of gold is three times smaller than the
maximum of drawdown of equities. The maximum drawdown of bonds is half of that for
gold and six times smaller than that for equities.

A figure on an empirical distribution is a quantile. Various quantiles are used in

investment performance and risk measurement, the most famous probably being Value-
At-Risk (VaR).

If we interpret maximum drawdown as a quantile on the empirical drawdown distribution,

we can say that maximum drawdown is the “drawdown-at-risk” (DaR) at a confidence
level of 100%. Other points on the drawdown distribution can be found the same way,
for example the median drawdown (DaR at 50% confidence) or the 95% DaR
(drawdown which is only exceeded in 5% of all cases).

The table below shows drawdown-at-risk for the three assets at confidence levels
commonly used in risk management…

3
Data source: http://www.gold.org/

© 2011, Andreas Steiner Consulting GmbH. All rights reserved. 3 / 12

 Confidence Level BSE SENSEX I-BEX TRI Gold (INR)

0.00% -0.01% 0.00% -0.01%

25.00% -6.74% -0.42% -3.18%

50.00% -19.73% -1.57% -7.08%

75.00% -36.33% -4.01% -11.29%

90.00% -46.63% -7.07% -14.00%

95.00% -50.10% -7.97% -16.12%

97.50% -54.08% -8.52% -17.74%

99.00% -57.02% -9.15% -18.77%

99.99% -60.85% -10.99% -21.45%

100.00% -60.91% -11.10% -21.73%

We can see that drawdown-at-risk is similar to value-at-risk in the sense that it described
one specific point on a distribution function: DaR is a quantile on the drawdown
distribution, VaR a quantile on the period return distribution.

Contrary to VaR, drawdown-at-risk is an interim loss measure. This means that not only
losses at the period end are considered, but also losses during the period.

Value-at-risk defines losses relative to the beginning value. DaR on the other hand
measures losses relative to the running maximum (also known as high water mark).

Drawdown-at-risk is a generalization of the maximum drawdown risk measure.

Maximum drawdown is an extremely pessimistic risk measure suitable for very
conservative investors; it is the loss of the unlucky investor who bought at the peak and
sold at the low. Drawdown-at-risk for confidence levels smaller than 100% are less
pessimistic and therefore suitable for less risk adverse investors.

In the literature, drawdown has mainly been used as a restriction in portfolio selection
problem, not as a component of the goal function to be optimized. Besides
computational issues, one reason for this was the difficulty of relating preferences for (or
rather against) drawdowns to investor utility functions. The drawdown-at-risk concept
can potentially address this issue: The confidence level parameter can be related to
investor loss aversion.

In what follows, we assume that investors like returns and dislike drawdowns for a given
level of confidence of 95%.

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Monte Carlo Portfolio Optimization
In Modern Portfolio Theory (MPT), portfolio constituent weights are variables under the
control of the investors. Given risk and return characteristics and investor preferences,
weights are determined and set by an optimizing individual. Asset returns on the other
hand are stochastic variables. One important result of MPT is that the relevant
opportunity set to investors does not consist of all possible portfolios, but “efficient”
portfolios only: investors choose among portfolios which deliver a maximum of return for
a given level of risk (or alternatively a minimum risk for a given level of return). The so-
called “efficient frontier” is the geometric location of all efficient portfolios. For an Indian
investor, the efficient frontier spanned by our previously introduced assets looks like
this…

In the above chart, volatilities and returns have been scaled from daily to annual values
for the sake of presentation4. Additionally, we have assumed that the asset weights
must be all larger than 0% and smaller than 100% and their sum equal to 100%. These
are the restrictions of the “traditional long only investor”. The leftmost point on the
efficient frontier is the minimum variance portfolio (which is located to the left of the
asset with the smallest volatility due to diversification benefits between the three assets
in this particular case here), the rightmost point the maximum return portfolio (which
always coincidences with the asset exhibiting the highest return in the case of lower
weights limits equal to 0% and upper weights limits equal to 100%). The efficient frontier
looks piecewise linear in this chart because we span it from eight efficient portfolios only.

For investment purposes, the composition of the frontier portfolios is even more
interesting than the efficient frontier itself…

4
Scaling daily results is only recommended if the time series are IID (independently and identically distributed over
time).

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 Composition of Mean Variance Frontier Portfolios
100.0%

90.0%

80.0%

70.0%

60.0%
Weight

Gold (INR) I-BEX TRI BSE SENSEX

50.0%

40.0%

30.0%

20.0%

10.0%

0.0%
4.37% 7.71% 11.06% 14.40% 17.74% 21.08% 24.42% 27.76%
Volatility

Both charts were created with the functions of our Advanced Portfolio Analytics Excel
add-in “ApaLibNET”.

Technically speaking, calculating the above mean/variance efficient frontier is a

quadratic programming exercise under restrictions. Various optimization algorithms exist
to derive it. We know would like to present an unorthodox approach which is based on
“random portfolios”. A random portfolio is a portfolio in which the constituent weights
satisfy all constraints and are generated in a random (or rather pseudo-random) fashion.

In the case of two assets, for example, we can generate one asset weight with the help
of Excel’s RAND() function. This built-in Excel function returns an equally distributed
random number between 0 and 1. The weight of the second asset is then found via the
constraint that the sum of weights must equal one: If for example w(1) = RAND() =
0.5346, then it follows immediately that w(2) = 1 – w(1) = 1 – 0.5346 = 0.4654.

While the above example calculations seem trivial, the general case involving many
assets and arbitrary linear constraints is not. Mathematically speaking, simulating
random asset weights involves sampling from the surface of a simplex in many
dimensions. Major issues involve a) ensuring the equal distribution of weights and b)
considering solutions on the vertices/edges of the simplex as well as interior points.

An excellent summary of the mathematics of simplex sampling can be found in Prof.

William T. Shaw’s paper Monte Carlo Portfolio Optimization for General Investor Risk-
Return Objectives and Arbitrary Return Distributions: A Solution for Long-Only
Portfolios.

Random portfolio generation has also been researched by Patrick Burns, originally in
the context of ex post performance analysis. His insights are accessible in the form of
commercial tools and consulting services on http://www.portfolioprobe.com/.

We have made investigations into the generation of random portfolios several years ago
and a free spreadsheet was available for download on
www.andreassteiner.net/performanceanalysis for many years. An effective

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implementation of random allocation algorithms can be found in our Advanced Portfolio
Analytics Excel add-in “ApaLibNET”.

We now illustrate Monte Carlo Optimization by deriving the mean/variance efficient

frontier shown before from random portfolios. We skip all mathematical details and
concentrate on the approach and results. The procedure is this…

1. Generate a large number (let’s say 50’000) of random portfolios

2. Calculate the return and volatility of all portfolios

3. Find the “top-left” corner of the convex hull around all portfolio in mean/volatility
space

This procedure results in the following efficient frontier…

We see that the random portfolios span the full opportunity space including inefficient
portfolios below the frontier. The efficient frontier itself is identical with the solution
derived from a traditional optimization algorithm.

Why Monte Carlo optimization?

 Many traditional portfolio optimization algorithms only work for a limited number
of goal functions. MC optimization works for any return and risk measures, like
drawdown-at-risk.

 Traditional portfolio optimization algorithms sometimes make assumptions about

the marginal distributions and dependence structure of constituent returns. MC
optimization algorithms work for arbitrary non-gaussian asset return distributions
and non-linear dependencies.

 Traditional portfolio optimization algorithms have problems dealing with complex

restrictions. It is no problem at all to, for example, incorporate cardinality
constraints (i.e. number of assets held is given) or a maximum drawdown-at-risk.

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  MC optimization produces interesting by-products. The set of efficient and
inefficient portfolios has many applications in applied investment risk
management. For example, we can determine reasonable expectations for a
median TE given lower and upper asset class bounds in institutional portfolios.
We might present such applications in future Research Notes.

The above advantages come at a cost of computational resources required. MC

optimization methods are computationally intense and require efficient numerical
implementation.

Example 1: Drawdown-At-Risk Efficient Asset

Allocation
In this first example, we use drawdown-at-risk as a goal function. We use Monte Carlo
optimization to determine the mean/DaR efficient frontier. Graphically, we get the
following result…

Note that the M/DaR Frontier is relatively flat, implying that trading expected portfolio
return can result in significant reductions in drawdown-at-risk.

We also see that the shape of the M/V and M/DaR frontiers is not that different, which is
an indication that there exists an inherent relationship exists between the risk measures
volatility and drawdown-at-risk. If we plot the volatility of the simulated portfolios against
their drawdown-at-risk, we get…

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The relationship between volatility and drawdown-at-risk is not a functional one, i.e.
plotting DaR against volatility does not result in a line. This means that there exist
portfolios with identical volatility risk but very different drawdown-at-risk.

As before, we can plot the allocation of the efficient portfolios on the mean/DaR
frontier…

We see that the allocation to gold is generally higher when optimizing drawdown-at-risk
instead of volatility. This is especially the case in more defensive portfolios, i.e. portfolios
towards the left on the mean/DaR frontier.

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Example 2: Drawdown-At-Risk Restrictions for M/V
Efficient Portfolios
Instead of optimizing drawdown-at-risk, we can also consider DaR as a constraint in the
context of a traditional mean/variance efficient optimization. The efficient frontiers in
mean/variance space with and without a drawdown-at-risk restriction of 15% are…

The drawdown-at-risk restriction renders the hi-volatility part of the opportunity space
infeasible. The maximum return portfolio in the restricted case has a volatility of
approximately 14%, while its volatility otherwise is approximately 28%.

The defensive left end of the frontier is not affected by the constraint on drawdown-at-
risk: the red area overlaps the grey area.

Example 2: Mean/DaR Efficient Frontier for S&P 500

What about applying drawdown-at-risk and Monte Carlo optimization to large asset
universes?

To see whether Drawdown-At-Risk and Monte Carlo Optimization can be used with
large amounts of data, we chose the constituents of the S&P 500 index as our universe.
We processed all stocks which had daily returns between 5 March 2001 and 4 March
2011, which resulted in a universe of 448 stocks.

Ten years of daily return data for 448 stocks resulted in a input data spreadsheet with
2610*448 = 1'169'280 cells, clearly a stress test for Microsoft’s Excel.

Nevertheless, we managed to generate the efficient Mean/DaR Frontier for 448 S&P
500 stocks derived form 50’000 simulated random portfolio. The result look like this…

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Compared to example 1, the efficient frontier is much steeper, implying that reducing
drawdown is not a “free lunch”, but reduces expected returns significantly in defensive to
moderately aggressive portfolios. Luckily, this is not the case for aggressive portfolios:
as the efficient frontier for portfolios with DaR larger than 50% is almost flat, reducing
DaR will not impact expected returns.

Over the same period, the average annualized return of the S&P 500 Total Return index
was approximately 4.5% at a DaR of approximately 41%. The Minimum DaR portfolio
has a drawdown of approximately 15% at a return of about 12%. This indicates that the
benefits from Mean/DaR optimization can be significant and that investing in the market-
cap weighted S&P 500 is highly inefficient when considering drawdown risk.

The computational burden in this example is massive. On a machine with dual

processors at 2.53GHz with 4GB of RAM, the computations took about 15 minutes to
complete. The computing performance bottleneck turned out to be not the computation
of random portfolio, but the transfer of the input data (return time series) from cells in
Excel to the calculation engine in a compiled C# DLL embedded in a XLL.

A Word Of Caution
What we do in this paper is in-sample portfolio optimization. A more realistic assessment
of the performance of drawdown-at-risk optimized portfolios would require out-of-sample
tests. The purpose of this research note is not to give investment advice, but to illustrate
the drawdown-at-risk and Monte Carlo simulation concepts. We would like to emphasis
that the findings in this paper do not constitute investment advice at all.

As drawdown risk is highly path- and scenario-dependent, we expect to see major

differences in in-sample and out-of-sample performance of optimized portfolios. On the
other hand, many other techniques are subject to the same issues. Hence, the practical
value of DaR and MC optimization will be mainly determined by their relative
performance to alternative approaches. We expect the estimation of ex ante asset
drawdown characteristics to be the most important issue.

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ApaLibNET Implementation
Without exceptions, all calculations were performed in Excel with our Advanced Portfolio
Analytics Add-In “ApaLibNET”. The following functions were used in deriving the mean /
drawdown-at-risk frontiers…

 apaDaR.Historical(Returns, ConfidenceLevel) – Calculates historical

drawdown-at-risk for a given return time series and confidence level.

 apaRandomWeights.Restricted(NumberOfAllcations, Budget,
LowerBounds, UpperBounds) - Calculates random allocations given a certain
total exposure (typically 100%) and a vector of lower and upper limits for the
constituent weigths.

More information about the add-in can be found on our websites

www.andreassteiner.net/performanceanalysis and www.andreassteiner.net/apalib.

March 2011,
Andreas Steiner

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