The

Chinese University of Hong Kong

Department of Finance
FIN6102 Quantitative Finance

ASSIGNMENT 2

Think Before You Leap –

Building a Minimum-Variance Portfolio

Team members

CHAN Pui Ching Angela (09046580)

CHIU Yu Cheuk Tommy (09046640)

LANDOLT Ryan Brooks (09068750)

LIN Tsun Kit Stephen (09028690)

January 30, 2010

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SECTION 1 Executive Summary
In this report we construct a minimum variance portfolio using ten
commonly traded stocks listed on the Hong Kong stock exchange.
We use three different methods to construct a portfolio that
minimizes the variance of the returns and then compare the
returns over different time periods with an equally weighted
portfolio of the same stocks.

Our findings show that with a relatively limited investment

universe, the equally weighted portfolio outperforms the minimum
variance portfolio in a bull market but the minimum variance
portfolios perform better in downturns such as the recent financial
crisis and fulfill their objective of risk mitigation.

We noted that the three methods used are all capable of creating
minimum variance portfolios with stable returns during crisis.
However, the dynamic nature of beta and the choice of the proxy
to the Market Portfolio have a notable effect to the performance of
the portfolios.

We conclude that the use of a minimum variance portfolio can add

value to a risk-averse investor whose choice of asset allocation
alternatives for a portfolio is limited, as is the case with many retail
investors.

SECTION 2 Introduction
To create an optimum investment portfolio, investors not only have
to combine several unique individual securities that have desirable
risk-return characteristics but also must consider the relationship
among these investments that will help meet their investment
objectives. The risk of an investment can be measured by
calculating the variance, or standard deviation of expected returns.
The larger the variance or standard deviation, the greater the
dispersion and greater the uncertainty of future returns of an
investment are likely to be. The correlation coefficient standardizes
and gives meaning to the number found in the covariance. The
investors can analyze the relationship between the return series of
different investments. By studying different portfolio possibilities
and quantifying the risk variable for a selected portfolio, investors
can understand the reason why they need to diversify their
portfolios and also what weightings of different investments they
should use to diversify.
In this study we have selected 10 assets listed on the Hong Kong
Stock Exchange and have constructed a minimum-variance
portfolio and an equally weighted portfolio to compare the
performance of the portfolios at different time periods in different
market conditions. We explain our observations by using different
calculation methods for the beta of each stock in our sample.

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 Section 3 of this report includes the data collected and the
methodology for the different calculations. Section 4 looks at the
results and discusses the observations. Section 5 concludes our
findings.

SECTION 3 Data and Methodology

3.1 Raw data used in the study

In this study, we are trying to form a portfolio for Hong Kong based
investors and as such, we have chosen 10 stocks listed on the
Hong Kong Stock Exchange. The choice of stocks mainly reflects
the economic performance of Hong Kong with a strong focus on
local stocks. We also included a few stocks with exposure in China
(CLP Group, Bank of East Asia) and all over the world as well
(Esprit, HSBC).

We then estimate the correlation of our selected stocks with the

Market Portfolio in Method 2 and Method 3. The Market Portfolio is
defined as the set of all risky assets in the world, and as such, is
impossible to obtain. For the purpose of our analysis, we have
chosen the Hang Seng Index (adjusted closing prices) as a proxy
for the Market Portfolio. As a way to compare results, we have also
used the MSCI World index as an alternative proxy.

All the stock prices we use are obtained from Yahoo Finance. We
use weekly adjusted closing prices (See Appendix 7.1 for
definition) in our calculation. We also sanitize the data to remove
duplicate entries and non-trading day prices.

The data we use is summarized in the table below:

Type Name Stock Code Source

Stock HSBC 0005 Yahoo Finance

Stock CLP Group 0002 Yahoo Finance

Stock Hong Kong Electric 0006 Yahoo Finance

Stock Bank of East Asia 0023 Yahoo Finance

Stock Sinopec 0386 Yahoo Finance

Stock Giordano 0709 Yahoo Finance

Stock Café de Coral 0341 Yahoo Finance

Stock Esprit 0330 Yahoo Finance

Stock Vitasoy 0345 Yahoo Finance

Stock SHK Properties 0016 Yahoo Finance

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 Index Hang Seng Index HSI Yahoo Finance

Index MSCI World MSCI Barra

Risk Free Exchange Fund 364-day HKMA

Rate Bill

3.2 Timeline of the study

To compare the result of using different optimization method, we

have defined specific points on the timeline as below:

T1 – T2: Estimation
Period
T2 – T3: Before
GFC

T2 – T4: In the midst of GFC

T2 – T5: Aftermath of the GFC

T1: Jan2, T2: Jul 3, T3: Dec 31, T4: Mar 9, T5: Dec 31,
2004 2006 2007 2009 2009

T1 – T2 is the estimation period. Weekly data is obtained and a

mean-variance portfolio is formed based on ex post analysis. T3 is
a point in time before the Global Financial Crisis (GFC). T4 is the
trough of the GFC. T5 is the end of 2009.

To obtain T4, we look at a plot of the HSI and identify the trough of
the index, which occurred on Mar 9, 2009.

• T1 – T2: Estimation period: Jan 2, 2004 to Jun 27, 2006

• T2: Portfolio formation: Jul 3, 2006

• T3: Before Global Financial Crisis: Dec 31, 2007

• T4: In the midst of Global Financial Crisis: Mar 9, 2009

• T5: End of 2009: Dec 31, 2009

3.3 Theory and Methodology

According to Markowitz Portfolio Theory, a portfolio of assets is

characterised solely by its return and risk:

Portfolio Expected Return:

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 E(Rp) = WTR
where W is an (n x 1) matrix of weights of individual assets

and R is an (n x 1) matrix of expected return of the

individual assets

Portfolio Risk:

σ(Rp) = {Wt COV W}½

where W is an (n x 1) matrix of weights of individual assets

and COV is the (n x n) covariance matrix of the individual

stocks.

In order to obtain the minimum variance portfolio, we optimize the

asset allocation such that the ex post portfolio risk is a minimum.
To do that, use the optimization function of Excel to derive a
minimum σ(Rp) by adjusting W.

In our case, the covariance matrix COV is a 10 x 10 matrix with

the diagonal elements the variance of the ten assets and the other
elements the covariance between individual terms. We have use
three different methods to calculate COV.

3.3.1 Method 1 – First principles

In method 1, we use the following formulae to calculate the

elements in COV:

Var (Ri) = σi2 = E(Ri)2 - E (Ri2)

Cov (Ri, Rj) = ρij σi σj

where Ri is the weekly return of asset i calculated using the
adjusted close prices from January 1, 2004 to June 27, 2006

and ρij is the correlation of the weekly return of asset i and asset j
during the same period.

We use the Correlation function in the Data Analysis tool of MS

Excel to obtain ρij. Since the covariance matrix is symmetric about
the diagonal, we only need to calculate 55 distinct elements of the
COV (10 variances plus 45 covariances).

By applying the minimizing Solver function (MS Excel) with

portfolio variance as calculated above, we obtain the percentage
weightings of the ten stocks of a minimum variance portfolio.

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3.3.2 Method 2 – Historical beta estimated using a single-index market
model

In method 2, we use the single-index market model:

Ri = ai + βiRm + ei
and the following formulae to calculate the elements in COV:

Var (Ri) = σi2 = βi2 σm2 + σ (ei)2

Cov (Ri, Rj) = βiβjσm 2

where βi is slope coefficient that relates the returns of asset i to
the return of the Market Portfolio

σm is the standard deviation of the Market Portfolio

σ (ei)2 is the error sum of squares of the regression of Ri on Rm

Ri is the weekly return of asset i calculated using the adjusted

close prices from January 1, 2004 to June 27, 2006

Rm is the weekly return of the Market Portfolio proxy

The Hang Seng Index has been used as a proxy for the market
portfolio.

Using this method, we only need to calculate 21 variables to

populate the covariance matrix (10 betas, 10 error sum of squares
and σm), thereby saving computing time, especially when the
number of assets is large.

Similar to Method 1, we have used the Solver function to arrive at

a minimum variance portfolio.

3.3.3 Method 3 – Adjusted beta

Using the Betas found in Method 2 above as input, we adjust the

beta using the formula below:

Adjusted β = a0 + a1β + e

where a0 = 1/3, a1 = 2/3

The adjustment assumes that the stock’s beta is dynamic and

adjusts over time. For our simplified analysis here, it is assumed
that the stock we have a beta approach 1 over time.

Then apply the same steps as in Method 2 to optimize the asset

allocation.

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3.3.4 Equally-weighted portfolio for comparison

For the purpose of establishing whether mean-variance

optimization delivers a higher performance (using Methods 1, 2 &
3), we also compare the results against that achieved by an
equally weighted portfolio (i.e. contributing 10% of the fund to
each of the 10 stocks being studied)

3.4 Indicators to be evaluated

1. Holding period returns from portfolio set-up date (Jul 3, 2006) to

three specific dates as below:

• Dec 31, 2007 (before global financial crisis)

• Mar 9, 2009 (low point during global financial crisis)

• Dec 31, 2009 (end of 2009)

2. Sharpe Ratios for the corresponding periods as in (1) above:

Sharpe Ratio

= (Annualized return – Risk-free rate) / Annualized Standard

Deviation

• Annualized return is calculated as below:

o (1 + holding period return) (245 days / # of days) - 1

• Annualizing the standard deviations of the estimation period

as below:

o (Portfolio variance on weekly return x 52)½

o Estimation period (instead of holding period) standard

deviations are chosen as we would like to assess the
actual return in the light of variance/risk expected at
the time of forming the portfolio (instead of actual risk
experienced during the holding periods)

• Risk-free rate: The HKMA Exchange Fund one-year bill yield

(average for the corresponding holding periods) is taken as
the risk-free rate for Sharpe Ratio purposes

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SECTION 4 Results and Discussion
4.1 Minimum Risk Portfolios and Asset Allocation

Since the covariance matrices using the three methods are all
different, it is natural that minimum portfolio risks calculated are
different. The portfolio risk is summarized in the table below:

Risk Measure Method 1 Method 2 Method 3

Portfolio Variance
0.0114% 0.0089% 0.0168%
(weekly return)

Portfolio Risk (annualized

7.7% 6.8% 9.3%
standard deviation)

Of the three methods applied, Method 2 has the lowest risk. Of the
10 stocks we used, 7 have a beta below 1.0 and most of those are
substantially lower than 1.0 (Appendix 7.2). Therefore, it is natural
that the adjusted betas in method 3, and therefore the elements in
COV will be larger than those in method 2, giving a higher
‘minimum’ portfolio risk.

The difference between Method 1 and Method 2 can be explained

by the use of the Market Portfolio as a common reference. As the
covariance of the errors in beta estimation, Cov (ei,ej), are not zero
in this data set, Method 2 does not agree exactly with Method 1.

The asset allocation based on the minimum variance analysis is

tabulated below:

Asset Asset Asset

Stock Allocation Allocation Allocation
Name
Code Using Using Using
Method 1 Method 2 Method 3

HSBC 0005 23.00% 13.16% 6.41%

CLP Group 0002 45.32% 42.24% 45.83%

Hong Kong Electric 0006 9.15% 24.97% 26.54%

Bank of East Asia 0023 1.73% 0.00% 0.00%

Sinopec 0386 0.00% 0.00% 0.00%

Giordano 0709 0.00% 0.00% 0.00%

Café de Coral 0341 2.98% 3.60% 3.64%

Esprit 0330 0.00% 0.00% 0.00%

Vitasoy 0345 17.82% 16.05% 17.57%

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SHK Properties 0016 0.00% 0.00% 0.00%

From the results of the minimum variance solver function, we find

that there are some stocks selected for our possible portfolio that
do not receive any weighting (i.e. the weight = 0%). This is the
case for four stocks with the Method 1 calculation:

• Sinopec (0386)

• Giordano (0709)

• Esprit Holdings (0330)

• SHK Properties (0016)

Method 2 and Method 3 also keep these four stocks out of the
minimum variance portfolio, and also do not allocate any
weighting to Bank of East Asia (0023).

Therefore, the weighting of the minimum variance portfolio only

comprises five to six stocks mostly concentrated in:

• CLP Holdings (0002): Ranging from 42.24% of the portfolio

in Method 2 to 45.83% in Method 3

• HK Electric (0006): Ranging from 9.15% in Method 1 to

26.54% in Method 3

• HSBC Holdings (0005): Ranging from 6.41% in Method 3 to

23.00% in Method 1

• Vitasoy Int’l (0345): Ranging from 16.05% in Method 2 to

17.82% in Method 1

With only five to six stocks even represented in the portfolio, the
results of the returns bring us to some interesting, and unexpected
conclusions outlined in section 4.2.

Alternatively, if we use MSCI World Index as a proxy (instead of the

Hang Seng Index) in Methods 2 and 3, we obtain different
minimum portfolio risk and arrive at different asset allocation
decisions:

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 Method 2 Method 3
Risk Measure
with MSCI with MSCI

Portfolio Variance
0.00602% 0.0102%
(weekly return)

Portfolio Risk (annualised

5.1% 7.3%
standard deviation)

Asset Asset
Allocation Allocation
Stock
Name Using Using
Code
Method 2 Method 3
with MSCI with MSCI

HSBC 0005 17.06% 15.80%

CLP Group 0002 33.24% 35.66%

Hong Kong Electric 0006 19.52% 19.54%

Bank of East Asia 0023 6.12% 5.85%

Sinopec 0386 1.15% 0.89%

Giordano 0709 2.09% 2.17%

Café de Coral 0341 3.54% 3.29%

Esprit 0330 2.05% 1.97%

Vitasoy 0345 11.19% 11.50%

SHK Properties 0016 4.03% 3.31%

In such case, all ten stocks will be included in the portfolio.

Another interesting side-fact to note is that in using the MSCI

World Index as a proxy, if compared against beta derived by using
the HSI as a proxy, lower betas are generated for most stocks in
our portfolio (Appendix 7.2). This may imply that to invest in a
local market, an already highly-diversified international investor,
for example a global mutual fund, could afford requiring a lower
return than a purely local and less diversified fund or investor.

4.2 Holding period returns (note: annualized returns shown in

the brackets)

KEY:
Best Performer Worst
Performer

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T2 – T3 (Bull Market)

Portfolio Holding
Annualized
Period
Return
Return

Hang Seng Index 70.97% 42.64%

Equal weight 62.47% 37.90%

Method 1 – First Principles 21.83% 13.97%

Minimum Risk Portfolios

Method 2 – HSI proxy 25.86% 16.45%

Method 2 – MSCI proxy 33.37% 21.01%

Method 3 – HSI proxy 27.89% 17.69%

Method 3 – MSCI proxy 32.31% 20.37%

We see that in an extended bull market period like that from July 3,
2006 to December 31, 2007 the equally weighted portfolio
(although while not as good as general Hang Seng Index
performance which was up about 70% in that time) outperformed
the minimum-variance portfolio by a large extent (62.47% to
Method 3’s 27.89%). It seems that this can be explained by the
higher risk that is taken by a holder of an equally weighted
portfolio.

T2 – T4 (In the midst of the GFC)

During the GFC, all minimum risk portfolios outperform the equally
weighted portfolio and the general Hang Seng Index:

Portfolio Holding
Annualized
Period
Return
Return

Hang Seng Index -30.26% -21.23%

Equal weight -9.97% -3.82%

Method 1 – First Principles 6.53% 2.38%

Method 2 – HSI proxy 20.57% 7.19%

Method 2 – MSCI proxy 4.59% 1.68%

Method 3 – HSI proxy 27.91% 9.57%

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 Method 3 – MSCI proxy 6.61% 2.41%

Minimum Risk Portfolios

To a certain extent, the minimum risk portfolios did give investors

the supposed protection during time of crisis, maintaining positive
returns while the general market tanks. In particular, Method 3
using the HSI as a proxy is the best performing portfolio during the
time of crisis.

It is interesting to note that Method 2 and Method 3 using the HSI

as a proxy has a very similar asset allocation percentage on three
very defensive stocks (CLP Group, Hong Kong Electric and Vitasoy).
The other three minimum risk portfolios all have a 15%+ allocation
on HSBC which suffered greatly during the GFC. It is can therefore
be deduced that the risk profile of HSBC has undergone a
fundamental change during the GFC and the ex post portfolio risk
calculated using data from T1 to T2 does not reflect the risk of
HSBC during the GFC.

T2 – T5 (The aftermath)

Portfolio Holding
Annualized
Period
Return
Return

Hang Seng Index 34.45% 8.76%

Equal weight 31.52% 8.08%

Method 1 – First Principles 32.57% 8.32%

Minimum Risk Portfolios

Method 2 – HSI proxy 39.15% 9.82%

Method 2 – MSCI proxy 29.95% 7.71%

Method 3 – HSI proxy 44.87% 11.08%

Method 3 – MSCI proxy 30.66% 7.88%

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As the market recovers, the equal weight portfolio returns to profit,
as expected. However, most of the minimum risk portfolios still
outperform the equal weight portfolio.

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 Graphical Analysis

50.0%
As can be seeFrom the graph, it can be seen that the minimum
variance portfolio formed using the HSI as a proxy for the Market
Portfolio generally maintains an annualized return of 5% to 25%
regardless of the general market performance. However, those
formed using Method 1 and the MSCI World Index as a proxy
sustained a period where annualized returns were below 5%. This
40.0%
is mostly explained by the higher weight on HSBC, where the risk
profile was fundamentally changed during the GFC.

In a bull market such as that seen in 2006 and 2007, a portfolio of

higher variance stocks can significantly outperform other
strategies that seek to minimize volatility. This is intuitive, as
volatility to the up side will be seen as a good thing. However, in
periods of market turmoil and recovery, it seems that constructing
a portfolio that minimizes the overall variance is a way to protect
the assets and avoid those stocks that are hit the hardest.

4.3 Sharpe Ratios

30.0%
In addition to the evaluation of the holding period returns and
annualized returns in the preceding section, we would like to
assess these annualized returns on a risk-adjusted basis.

The Sharpe Ratios calculated here are the actual average returns
for the holding periods per unit of historical variability as derived
nualised Return

from the estimation period (Jan 2004 – Jun 2006)

20.0%
The table below shows that the equal weight portfolio outperforms
minimum-variance portfolios, on a risk adjusted basis under all
methods during the market downturn (Jul 3, 2006 – Dec 31, 2007),
while we see the opposite trend with the general market upturn.

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 Portfolio / Sharpe Ratio T2 – T3 T2 – T4 T2 – T5
2.49 to -0.46 to 0.44 to
Equal weight
2.72 -0.50 0.48
Minimum Risk Portfolios Method 1 – First
1.34 -0.02 0.82
Principles

Method 2 – HSI proxy 1.88 0.69 1.15

Method 2 – MSCI proxy 3.10 -0.15 1.02

Method 3 – HSI proxy 1.50 0.75 0.97

Method 3 – MSCI proxy 2.29 -0.02 0.81

As expected, the minimum-variance portfolios perform significantly

better than the equal weight portfolio during depressed times (T2 –
T4, T2 – T5). For T2 – T1 however, the Sharpe ratio of the portfolios
formed by using MSCI World Index as a proxy have a very high
Sharpe ratio due to its low portfolio risk (Section 4.1). This again
could be explained by the dynamic nature of the beta estimate: it
is likely that the risk profile of the stocks change during T2 – T3.

One point worth mentioning about a negative Sharpe Ratio is using

minimum-variance portfolio (Method 1) as an example, for the
holding period of Jul 3, 2006 to Mar 9, 2009 (T2 – T4), even though
it was still earning a positive annualized return (2.38%), the
corresponding Sharpe Ratio is marginally negative (-0.02), this
means the related portfolio’s annual return is less than the same
period’s risk free rate.

SECTION 5 Conclusion
We have picked ten stocks from those listed on the Hong Kong
stock exchange and formed minimum-variance portfolios using
different methodologies. The performance of the portfolio vis-à-vis
an equal weight portfolio is compared over a period of boom and
bust.

To conclude, we summarize our major take-away from this study in

the following sections

5.1 Minimum-variance Portfolio Outperforms During Times of

Crisis

Of all the minimum-variance portfolios we have constructed, all

outperform the equal weight portfolio as well as the Hang Seng
Index during T2 – T4 and T2 – T5. Our research indicates that
minimum-variance portfolios do serve the purpose of risk
mitigation during times of crisis.

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 We conclude that the use of a minimum variance portfolio can add
value to a risk-averse investor whose choice of asset allocation
alternatives for a portfolio is limited, as is the case with many retail
investors.

5.2 Computing Efficiency is Higher Using Methods 2 and 3

Method 2 and 3 are far more efficient in terms of computer power.

Instead of calculating half of the elements in the covariance matrix
COV, we only need to compute the variance of the Market
Portfolios, the betas and the error sum of squares.

When the number of assets involved is large, this can make a big
difference.

5.3 Choice of the Market Portfolio is Important

It is generally accepted that the true Market Portfolio is

unobservable. Two different proxies have been used to substitute
for the Market Portfolio, yielding vastly different results.

5.4 Beta is Probably Dynamic and Possibly Unstable in Short

Run

We have observed anomalies in the portfolio formed using MSCI

Index as a proxy. We postulate that the methodology used to form
the portfolio is reasonable. But subsequent changes in the risk
profiles of the stocks (most notably HSBC) might have weakened
the protection offered by the portfolio formed with historical data
during abnormal times.

SECTION 6 References
(1) SHARPE, William F. : The Sharpe Ratio (1994)

(2) Yahoo Finance Hong Kong (http://hk.finance.yahoo.com/)

(3) Hong Kong Monetary Authority’s Monthly Statistical Bulletin (Jan

2010 – Issue No. 185)

(4) MSCI Barra : MSCI World Index represents a free float-adjusted

market capitalization weighted index that is designed to
measure the equity market performance of developed markets.
(As of June 2007 the MSCI World Index consisted of the
following 23 developed market country indices: Australia,
Austria, Belgium, Canada, Denmark, Finland, France, Germany,
Greece, Hong Kong, Ireland, Italy, Japan, Netherlands, New
Zealand, Norway, Portugal, Singapore, Spain, Sweden,
Switzerland, the United Kingdom, and the United States.)

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SECTION 7 Appendix
7.1 Definition of Adjusted Closing Price

Adjusted Close provides the closing price for the requested day,
week, or month, adjusted for all applicable splits and dividend
distributions. Data is adjusted using appropriate split and dividend
multipliers, adhering to Center for Research in Security Prices
(CRSP) standards. Split multipliers are determined by the split
ratio. For instance, in a 2 for 1 split, the pre-split data is multiplied
by 0.5. Dividend multipliers are calculated based on dividend as a
percentage of the cum-dividend stock price, primarily to avoid
negative historical pricing. For example, when a $0.08 cash
dividend is distributed on Feb 19 (ex-date), and the Feb 18 closing
price was 24.96, the pre-dividend data is multiplied by (1-
0.08/24.96) = 0.9968. Below is a detailed example of adjusted
close calculations.

7.2 Betas

HSI Method HSI Method MSCI MSCI

Stock / Beta
2 3 Method 2 Method 3

HSBC 0.68 0.79 0.38 0.59

CLP Group 0.19 0.46 0.06 0.37

Hong Kong
Electric 0.28 0.52 0.24 0.49

Bank of East
Asia 0.82 0.88 0.33 0.55

Sinopec 1.68 1.45 0.57 0.71

Giordano 0.77 0.85 0.16 0.44

Café de Coral 0.42 0.61 0.37 0.58

Esprit 1.08 1.06 0.32 0.55

Vitasoy 0.14 0.42 0.18 0.45

SHK Properties 1.24 1.16 0.52 0.68

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