Defensive Portfolio Construction
Based on Extreme Value at Risk
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Frank Schmielewski
is managing director
and chief scientist at
RC Banken Group in
Buxtehude, Germany.
schmielewski.frank@rc-banken.de
Stoyan Stoyanov
is a research professor in
the College of Business at
Stony Brook University in
Stony Brook, NY.
stoyan.stoyanov@stonybrook.edu
42 Defensive Portfolio Construction Based on Extreme Value at R isk Spring 2017
Frank Schmielewski and Stoyan Stoyanov
L
ow-volatility strategies have been
found empirically to be conservative
portfolios delivering returns com-
parable or higher than the market
portfolio (see, for example, Blitz and Vliet
[2007] and Walkshausl [2014]). There are two
main methods of construction: The portfolio
can be obtained by (1) minimizing portfolio
variance subject to some weight constraints
or (2) a two-step process in which stocks are
ranked by a risk-related criterion (e.g., histor-
ical volatility or beta) and then low-volatility
stocks are selected and weighted on an ad hoc
basis using equal weights or cap weights.
A problem of low-volatility portfolios
documented in the literature is the concen-
tration in low-volatility stocks (see DeMiguel
etal. [2009] and Clarke etal. [2011]). Such
biases can lead to concentrations in certain
industries that tend to be less volatile in cer-
tain time periods (see Chan etal. [1999]) and
are a source of strategy-specific risk.
In this article, we explore a different
methodology for defensive low-risk portfolio
construction that is not based on volatility
but on a tail-risk measure called extreme
Value at Risk (eVaR). Our approach follows
the second method; that is, stocks are ranked
by their eVaRthe ones with the lowest risk
are selected and equally weighted. The eVaR
measure is the Value at Risk (VaR) of the
return distribution of each stock computed
at a low-tail probability level using extreme
value theory (EVT) to get a more accurate
approximation of the low quantile needed
because of the non-Gaussian behavior of
stock returns (see Stoyanov etal. [2011] and
Schmielewski and Schwehm [2014]). Our
method, therefore, belongs to the class of
low-risk strategies in which risk refers to a
tail-risk measure.
We run an extensive empirical study
on a large universe of international stocks to
compare the properties of the low-eVaR port-
folio and the low-volatility portfolio based
on the same ranking methodology. Our first
main finding is that the low-eVaR portfolio
has better risk and performance characteris-
tics and a better downside risk profile. Our
second main finding is that the sector and
regional concentration of the low-eVaR
portfolio is lower than that of the low-
volatility portfolio. To make sure the con-
clusions are robust, we explore four different
estimations of eVaR and find similar results.
Finally, we use the FamaFrenchCarhart
factors to compare the risk premium struc-
ture across the two methodologies and also to
look for a possible explanation of the better
downside risk profile of low-eVaR portfolios.
Although we find statistically significant dif-
ferences by conditioning on U.S. recessions,
the systematic exposures cannot explain the
better downside risk profile of the low-eVaR
strategy, which, as a result, turns out to be a
strategy-specific characteristic.
 METHODOLOGY
The portfolio construction method is based on the
eVaR of each stock, which is a forecast of VaR com-
puted through EVT. There are different ways in which
EVT can be applied (see Embrechts etal. [2004] and
McNeil etal. [2005]). To verify the robustness of the
conclusions, we adopt four different methods. In this
section, we first describe the methods and then outline
the portfolio construction approach, and, finally, we
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explain the risk and performance characteristics used
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for strategy comparison.
eVaR
EVT provides a model for the extreme tail of the
distribution and has been applied in finance to estimate
probabilities of extreme losses or extreme loss quantiles.
The appeal of EVT is that it provides a model for the
extreme tail without heavy assumptions on the return
distribution.
There are two ways to apply EVT in practice:
(1) the block-of-maxima method (BM) and (2) peaks-over-
threshold method (POT) (see McNeil etal. [2005]). BM
divides the sample period into blocks of equal size,
which typically match the risk horizon (e.g., one month
or one week) and computes the maximum loss in each
block. The asymptotic distribution of the maxima is the
Generalized Extreme Value Distribution (GEV). POT
sets a high threshold and considers the extreme losses
beyond the threshold. The asymptotic distribution of
the excess losses beyond the threshold is the Generalized
Pareto Distribution (GPD).1
In our empirical study, we compute eVaR in two
different ways: (1) we apply both methods directly on
the stock returns and (2) we combine both methods
with a GARCH(1,1) filter. The GARCH (generalized
autoregressive conditional heteroskadasticity) model
explains the clustering of volatility of the stock returns,
and EVT is applied to the residual. In the literature, both
techniques have been used (see, for example, Stoyanov
etal. [2017] and the references therein). In total, we have
four different ways of calculating eVaR.
The method of applying GPD and GEV directly
to the return distribution is straightforward; the distri-
bution parameters are estimated using the maximum-
likelihood method. The block size is set to 10 working
days, and the high threshold in the POT is set to the
Spring 2017
90% quantile of the daily loss distribution, which is a
common choice (see Stoyanov etal. [2017]). eVaR is then
estimated as the 99% quantile of the fitted distributions.
In the case of a GARCH(1,1) filter, we assume the
return has the following structure,
rt = + t Z t
t2 = K + at21 + b t21 (1)
where t=tZt. The conditional eVaR at time t fore-
casted for 10 working days ahead is given by
p ( X t +10 | I t ) = + t +10|tVaR
VaR p (Z ) (2)
where It denotes the information available at time t and
p (Z ) is estimated as the 99% quantile of the GPD
VaR
or the GEV distribution estimated from the normalized
residual Zt. The parameters of the filter are estimated
from daily data; the estimation of GEV and GPD follows
the steps shown here.
Portfolio Construction
The portfolio construction method consists of the
following steps. For a given eVaR calculation method,
at each rebalancing that occurs every quarter, the next
steps are followed:
1. The eVaR of all stocks is calculated using the most
recent 750 daily returns in local currency.
2. The stocks are ranked by their eVaR in increasing
order.
3. The top 200 low-risk stocks are selected and are
equally weighted.2 No constraints of any type are
applied.
Furthermore, we apply a one-way transaction cost
of 50 basis points. Also, our universe of stocks has no
survivorship biasesthat is, if a stock gets delisted, the
portfolio loses the invested amount in that stock. We
use returns in local currency in the eVaR calculation to
have a ranking invariant of currency risks.
Finally, apart from eVaR we apply the same algo-
rithm for a strategy in which stocks are ranked by their
historical volatility using the same estimation time
window. This allows us to compare the properties of
the volatility-based strategy to the eVaR strategies on
an equal basis.
The Journal of Portfolio M anagement 43
 Risk and Performance Characteristics Exhibit1
Total Number of Stocks per Sector and Region
To compare the performance of the strategies,
we use some standard performance measures and some
that are more sensitive to tail losses. We look at the
standard realized return, volatility, and Sharpe ratio, but
we also consider the downside deviation, the 99% VaR
of the realized return distribution, and the drawdowns.
Finally, we calculate the pain index (PI),
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1 T max
PI = (St St )+ , (3)
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n t =1

and the ulcer index (UI),

1 T max
UI =
n t =1
(St St )2+ , (4)

in which (x) + = max(x,0), Stmax = max t S denotes

the running maximum, and n = #{(Stmax St )+ > 0,
t=1,,T} denotes the number of drawdowns. For
a motivation, see Schmielewski and Schwehm [2014].
DATA
The stock universe consists of 9,472 stocks in total
from 48 developed and emerging markets. The criteria
for selection is that market capitalization should be above
$1 billion.3 Exhibit1 provides details on the number of
stocks per sector and region globally. The time period
for backtesting the performance of the strategies is from
April 1995 to December 2014.
The factor returns of the global market, size, value,
and momentum factors are taken from the data library
of K. French that is available online.4 The regressions
are estimated with monthly returns. To define the time
periods of U.S. expansions and recessions, we use data
from the National Bureau of Economic Research.5
EMPIRICAL RESULTS
In this section, we describe the empirical results
starting with the risk and performance characteristics.
We find that the eVaR strategies have better tail-risk
characteristics measured by a variety of different mea-
sures, better returns than the low-volatility portfolio,
and better Sharpe ratios. Both low-risk strategies sig-
nificantly outperform the MSCI World Index, which
we use only as a broad benchmark because the constit-
uent stocks are not the same. We also conclude that the
concentration of the low-eVaR portfolios in both sec-
tors and regions is lower than that of the low-volatility
portfolio.
Second, we compare the structure of the risk pre-
mium of the low-eVaR and the low-volatility strategies
using the classical FamaFrench three-factor model.
We find that the exposures to the traditional factors are
very similar in the entire period and also if we condition on
U.S. expansions. Although we find some differences in the
factor structure during U.S. recessions, they do not explain
the better downside risk profile of low-eVaR strategies.
Risk and Performance
Exhibit2 provides a comparison of the perfor-
mance of the strategies. The plot shows the evolution of
the value of each portfolio with $100 invested in April
1995. The risk and performance statistics are available
in Exhibit3.
The low-eVaR strategies exhibit slightly higher
realized returns and slightly better volatilities, which
translate into higher Sharpe ratios than the low-volatility
strategy. Their downside riskas measured by downside
deviation, eVaR, the different drawdown statistics, PI, and
UIis also better than that of the low-volatility strategy.

44 Defensive Portfolio Construction Based on Extreme Value at R isk Spring 2017

 Across the low-eVaR strategies, it is interesting
to see that the GARCH filter does not contribute any
value: The risk and the performance statistics of those
that utilize the filter are quite similar to those that do
not. Even though econometrically it makes sense to
Exhibit2
A Performance Comparison: $100 Invested in Each
Strategy in April 1995
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Exhibit3
Risk and Performance Statistics of the Low-eVaR Strategy, the Low-Volatility Strategy, and the MSCI
WorldIndex
Spring 2017
utilize it, the lack of value added is most likely due to
the big difference between the data frequency used for
estimation and the rebalancing frequency.
The MSCI World Index in Exhibit3 is used only
as a broad benchmark, because its constituents are a
subset of the constituents of the other strategies; clearly,
the risk premium of the strategies is driven by factors
beyond the market factor. It is nevertheless important
to consider the improvement in the risk statistics of the
strategies relative to that index: They all exhibit much
lower downside risks, even though the stock universe is
larger and includes riskier stocks on a stand-alone basis.
To measure the concentration of the strategies
in different sectors and regions, we use the notion of
effective number of stocks translated into sectors or
regions. The effective number of sectors/regions is
defined as
1
EN = (5)
k
w2
i =1 i
where k denotes the number of sectors/regions and wi is
the total weight allocated to the corresponding industry/
region. In the case of equally weighted allocation, the
EN coincides with the actual number of sectors/regions.
A lower EN statistic indicates a higher concentration.
Exhibits 4 and 5 illustrate the allocation to the
regions and sectors through time for the low-volatility
strategy (left plots) and the low-eVaR strategy
based on GPD with no GARCH filter (right plots).
The Journal of Portfolio M anagement 45
 Exhibit4
Allocation to Regions of the Low-Volatility Strategy (Left) and the Low-eVaR Strategy (Right)
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Note: The low-eVaR implements the GPD method; we find similar results with the other methods.
The corresponding plots of the other low-eVaR strate-
gies are very similar. Even though one can find similar
trends in the allocations, the low-eVaR strategy exhibits
a visibly lower concentration. The trade-off in Exhibit4
appears to be primarily between the allocation to North
America and the emerging markets. The fact that there
are similar trends is natural given that tail-risk mea-
sures are sensitive to the scale parameter (see Stoyanov
etal. [2013]).
In contrast, Exhibit5 shows more complicated
dynamics. In the low-volatility regime before the finan-
cial crisis of 2008, the low-volatility strategy tended to
concentrate on the financial and utilities sectors (about
70% of the total allocation). As the crisis unfolded and
volatilities increased across all sectors, the sector allo-
cations gradually become less concentrated, with the
financial sector shrinking to a small fraction of its alloca-
tion in 2004. In contrast, the low-eVaR strategy appears
to be much more balanced, which can be explained
by the fact that the allocation is affected not only by
volatility but also by the stocks tail risk; low volatility
does not necessarily mean low tail risk.
Those observations on the relative concentration
are confirmed by the numerical data in Exhibits 6 and 7,
which is based on the average sector allocation from
46 Defensive Portfolio Construction Based on Extreme Value at R isk Spring 2017
1995 to 2015. The EN statistic is higher for all low-eVaR
strategies; the GPD method tends to produce a relatively
more diversified allocation either with or without the
GARCH filter.
Structure of the Risk Premium
The performance results in Exhibit3 indicate
that the low-eVaR strategies tend to dominate the
low-volatility strategy in two aspects: (1) the supe-
rior realized performance over the entire period
and (2) better downside risk prof ile of the return
distribution. Next, we look at the exposures in the
traditional FamaFrenchCarhart four-factor model
(see Fama and French [1992] and Carhart [1992]) to
see if these differences arise from different exposures
to the systematic factors. We also look for a possible
explanation for the second aspect mentioned, which
in theory might be caused by a factor that is significant
for the low-eVaR strategy and insignificant for the
low-volatility strategy.
We run the factor model unconditionally using
the data in the entire period from 1995 to 2015 and
also by conditioning on U.S. expansions and recessions.
The estimated exposures, confidence intervals, and
 Exhibit5
Allocation to Sectors of the Low-Volatility Strategy (Left) and the Low-eVaR Strategy (Right),
January 2004July 2009
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Note: The low-eVaR implements the GPD method; we find similar results with the other methods.

Exhibit6
The Effective Number of Regions across Strategies Computed from the Average Allocations, 19952015

goodness of fit are available in Exhibit8, which is orga-
nized in three panels. We include the regression results
of the GPD and GEV strategies, which are representative
of all low-eVaR strategies.6
The results in Panel A, which are based on the full
sample, show no significant differences in the structure
of the risk premium of the three strategies. The three
exhibit a significant exposure to the market factor and
a value tilt. The size and momentum exposures are
insignificant. The GPD strategy appears to have a sta-
tistically significant higher exposure to the market factor
at the 95% level than the other two. The source of the
excess performance is either the intercept term (GEV)
or a combination of the intercept and a higher exposure
to the market factor (GPD).
Panel B reveals a similar picture. The case of reces-
sions in Panel C shows a different structure in the risk pre-
mium. None of the strategies has a significant intercept.
The GEV strategy has a value and a momentum tilt,
while the GPD has a significant exposure only to the
market index. The low-volatility strategy has a statisti-
cally significant value tilt.

Spring 2017 The Journal of Portfolio M anagement 47

 Exhibit7
The Effective Number of Sectors across All Strategies Computed from the Average Allocations, 19952015
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Exhibit8
The Regression Coefficients, the 95% Confidence Bounds, and the Adjusted R2 of the Traditional Four-Factor
Model, Run on the Full Period and Conditioned on Expansions and Recessions

Even though the differences in the exposures can
explain the differences in the average returns during
recessions, they cannot account for the differences in the
downside of the return distribution. The GPD strategy
has a significant exposure only to the market factor and
yet it exhibits a difference in both the extreme and the
average drawdowns. As a result, we conclude that the
reason for the differences in the downside is strategy
specific and is contained in the residual; that is, although
in theory there may be a factor causing these differences,
it is not one of the common factors suggested in the
literature. Most likely, it is a consequence of the more

48 Defensive Portfolio Construction Based on Extreme Value at R isk Spring 2017

 balanced allocation across sectors, which exposes the
strategy to smaller sector-specific risks.
CONCLUSION
In this article, we compare a low-volatility strategy
and low-risk strategies based on eVaR constructed from
a large universe of international stocks in the period
from 1995 to 2015. We adopt four different methodolo-
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gies to compute eVaR based on EVT and a GARCH(1,1)
filter, which is a common model for the clustering of
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volatility effect. The strategies are compared in terms of
the risk-adjusted performance and also in terms of the
concentration of the allocations to sectors and regions.
We also compare the structure of the risk premium using
the common FamaFrenchCarhart four-factor model.
We find that the low-eVaR strategies exhibit better
risk and performance statistics and also a better down-
side of the return distribution measured by a variety of
statistics. The common problem of high sector concen-
trations of low-volatility strategies is less pronounced in
the low-eVaR strategies because of the additional infor-
mation contained in the tail behavior. Finally, we find
that the structure of the risk premium is very similar in
expansions; and although we detect some differences in
recessions, they cannot explain the better downside risk
profile of the low-eVaR strategies. We conclude that the
better downside is a strategy-specific feature most likely
caused by the more diversified sector allocation.
More generally, low-eVaR strategies represent
an interesting alternative to low-volatility strategies.
Low-eVaR strategies are methodologically rather dif-
ferent and can be viewed as a way to diversify the risk
of crowding into one particular low-risk methodology.
ENDNOTES
1
The two families of distributions are defined as
1
1 1 + ( x ) , =/ 0
G , , ( x ) =
1 exp( ( x )/ ), = 0
1
exp 1 + ( x ) , =/ 0
H , , ( x ) =
exp( exp( ( x )/ )), = 0
Spring 2017
where G ,, (x) denotes the GPD, and H ,, (x) denotes the
GEV. In both cases, the parameter is referred to as the
tail index and depends on the degree of heavy-tailedness of
the loss distribution. The parameters and are a loca-
tion and scale parameter, respectively. The eVaR at a tail
probability of p is simply the (1-p) quantile of the GEV or
GPD distributionsthat is, it is a loss threshold violated with
a probability of p.
2
We also implemented two modif ications of this
methodselecting the top 50 and the top 100 stocksand
found similar conclusions. The difference between the three
modifications is the relative stability of the sector and country
allocations.
3
We also applied the same strategies to the subuniverse
of the U.S. stocks and found similar results.
4
The factor returns are available at mba.tuck.dartmouth
.edu/pages/faculty/ken.french/data_library.html.
5
The U.S. business economic cycles are available online
at www.nber.org/cycles.html.
6
For better readability of the regression output, all
returns used in the regressions are in percentages. That is,
the coefficients are effectively scaled by a factor of 100.
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50 Defensive Portfolio Construction Based on Extreme Value at R isk Spring 2017