OnCertainGeometricAspectsofPortfolioOptimisationwithHigher

Moments
*

GustavoM.deAthaydeandRenatoG.FlresJr.
BancoItaS.A.,SoPauloEPGE/FundaoGetulioVargas,Rio

ABSTRACT

Wediscussgeometricpropertiesrelatedtotheminimisationofaportfoliokurtosisgiven
itsfirsttwooddmoments,consideringarisk-lessassetandallowingforshortsales.The
findingsaregeneralisedfortheminimisationofanygivenevenportfoliomomentwith
fixed excess return and skewness,and thenfor the case in which only excess return is
constrained.Anexamplewithtworiskyassetsprovidesabetterinsightontheproblems
relatedtothesolutions.Theimportanceofthegeometricpropertiesandtheiruseinthe
highermomentsportfoliochoicecontextishighlighted.

JELclassification:C49;C61;C63.

(Thisversion:August5,2002)

*
This is a paper specially prepared for the Multi-Moment Capital Asset Pricing Models and
Related Topics Workshop held in Paris on April 29, 2002. We thank all the participants for
comments and lively related discussions and, particularly, Emmanuel Jurczenko and Bertrand
Maillet, the workshop organisers on behalf of the Finance-sur-Seine Association. All ideas,
affirmativesandmistakesareourown.
1. Introduction.

Portfolio optimisation taking into account more than the first two moments has been
receivingrenewedinterestinthepastyears.Beitonthetheoreticalsideincludingits
links with the CAPM extensions -, or on what relates to econometric tests or updates
based on higher conditional moments, works like Adcock (2002), Adcock and Shutes
(1999), Athayde and Flres (1997, 2001, 2002), Jurczenko and Maillet (2001, 2002),
Pedersen and Satchell (1998), or Athayde and Flres (2000), Barone-Adesi (1985),
Harvey and Siddique (1999, 2000), Hwang and Satchell (1999) and Pedersen and
Satchell (2000), far from exhausting the full list of contributions, pay good witness to
thegrowingawarenessoftheimportanceofhighermomentsinbothlinesofresearch.
Since Athayde and Flres (1997), we have developed a systematic way to treat
the key optimisation problems posed to anyone dealing with higher moments in
portfolio theory. The approach uses a new notation to represent any moments tensor
related to a multivariate random vector of asset returns, and can be used either in a
utility maximising context or if optimal portfolios are defined by preference relations.
The new notation seemed necessary in order to treat the problem in an absolutely
general setting, which means both in the maximum order p of portfolio moments of
interestandinthepossiblepatternsoftheskewnessorhigherordertensors.Thelatteris
crucial as many works generalising the subject consider only the marginal higher
moments of the returnsvector, plainly disregarding any co-moment of the same order.
Thoughthefullsetofco-momentscanquicklybecomeprohibitivewhat,beyondother
questions,mayposeseriouseconometricestimationproblemsfortheapplications-,and
simplifyinghypothesesonitspatternwillusuallybeimposedinpractice,itisimportant
to have a way to study the general solution to the problem, irrespective of further
assumptionsthatmightbeimposed.
The utility function approach, given its more rigid theoretical constraints, and
the debates involving any non-normality-implying (utility) function proposed, seems
more suitable for theoretical developments related, for instance, to the CAPM.
Preferenceorderingofportfolios,maderigorousbyScottandHorvath(1980),canlead
tomoreinterestingresultsinthestrictportfoliooptimisationcontext.
In this paper, we discuss an interesting geometric structure that arises when
optimisinganevenmomentsubjecttooddmomentsconstraints.Asusual,agentslike
oddmomentsanddislikeevenones.
Thestructurestudiednottheonlyrelevantoneinthehighermomentscontext
bearsimportantconsequencesand shedslightonthegeometryofefficientportfolios
sets in moments space. We believe that its implications have not been fully exploited
yet.Moreover,finaltestingofthegainsbroughtoutbyusinghighermomentsreliesin
extensive practical applications of the new results. These, in turn, require proper
software tools for solving the non-linear systems and optimisation problems involved.
Better knowledge of the surfaces (or manifolds) related to them may greatly improve
thesoftwaredesign.
This paper is organised as follows. The next section discusses the optimisation
ofvariance,andthenkurtosis,giventhefirstandthirddesiredportfoliomoments;while
sectionthreediscusseshowtheseresultscouldstillbegeneralised.Sectionfourdraws,
through an example, a few more properties and analyses the sensitivity of certain
solutions. The final section concludes by explaining how the resultscan be useful ina
duality context and sets a few lines of further research. An Appendix provides a brief
explanationofthenotationused.

2. Minimalvariancesandkurtosessubjecttothefirsttwooddmoments.

Even moments, being always non-negative, are duly associated with spread, and both
varianceandkurtosisareusedassimplenumericalsummariesofthedispersionofaset
of observations. For fixed portfolio return and skewness, the latter should perhaps be
more used in practice as an alternative objective function, given the frequency with
whichthefat-tailedeffectinstockreturnshasbeendetected.Ifweminimisethefourth
moment, we shall be directly attacking the heavy extremes of the density, the ultimate
culpritsofthehighvolatilityanduncertaintyofreturns.Mostmeasuresofriskfocused
ontheworstscenarios,liketheVaR,wouldprobablybemoresensitivetovariationsin
the fourth moment rather than in variance. This sort of behaviour will be further
examined in the example in section 4. The material in this section draws on parts of
AthaydeandFlres(2001)whereacompletesolutiontothethreemomentsportfolio
problemisfoundandAthaydeandFlres(2002),forthedevelopmentsrelatedtothe
kurtosis;proofsomittedherecanbefoundinthesepapers.

2.1.Homotheticpropertiesoftheminimumvarianceset.
Minimising the variance, for a given mean return and skewness, amounts to find the
solutiontotheproblem:
[ ] )) ( ( )] ) 1 1 ( ( ) ( [
3
,
2
,
1
,
1 2
,
3

+ + + = M r M r E M L Min
p
f p
,(1)
whereM
1
, M
2
and M
3
are, resp., the matrices related to the first, second and third
moments tensors
1
, is the vector of n portfolio weights where short sales are
allowed,r
f
istherisklessrateofreturn,[1]standsforanx1vectorof1s,thelambdas
are Lagrange multipliers and the two remaining symbols are the -portfolio (given)
meanreturnandskewness.
Callingx=M
1
[1]r
f
,thevectorofmeanexcessreturns,and
R=E(r
p
)r
f
theset(excess)portfolioreturn,
thesolutionto(1)isfoundbysolvingthen-equationsnon-linearsystem,
) (
) ( ) (
3
2
2 4 0
2 0
2
2 4 0
2 4
2
3 3

= M
A A A
R A A
x
A A A
A R A
M
p p
.(2)
wherethescalars:
x M x A
1
2
,
0

= ,
) (
3
1
2
,
2
=

M M x A ,(3)
) ( ) (
3
1
2 3
,
4
=

M M M A ,
havesubscriptscorrespondingtotheirdegreeofhomogeneityas(real)functionsofthe
vector . A
0
and A
4
, in particular, are positive because the inverse of the covariance
matrixispositivedefinite.
Pre-multiplying(2)bytheverysolutions
,
,givestheoptimalvariance(s):
2
2 4 0
2
0 2
2
4
) (
) ( 2
3 3
2
A A A
A R A R A
p p
p

+
=

,(4)
anexpressionwhereboththenumeratoranddenominatorarepositive.
Thefollowingpropositionisfundamental:

Proposition1:Foragivenk,let definetheminimumvarianceportfoliowhenR=1
and k y
p
= =
3
3
3
, and
2
p
be the corresponding minimum variance, THEN for all
optimal portfolios related to return and skewness pairs (R,
3
p
) such that
3 3
3
R k
p
= ,
or kR y =
3
,thesolutionto(1)willbe R = ,withcorrespondingminimumvariance
2
2 2
R
p p
= .

The above result implies that along the direction defined in the returns x
skewnessplanby kR y =
3
,theoptimalvarianceasafunctionoftheexcessreturnwill
be a parabola. Taking now the three dimensional (3D) space where the standard
deviation
2
2
2
y
p
= axisisadded,inthehalf-planeformedbyaspecificdirectionkin
Rxy
3
space
2
andthepositivepartofthestandarddeviationaxis,theoptimalportfolio
surfacewillbereducedtothestraightline 0 ,
1
2
2 2

+
= u
k
u
y y
p p
3
.As
2
p
y differs
withk,theanglethatthislinemakeswiththestandarddeviationaxisvariesalsowithk,.
ThePropositionhasthenafarreachingconsequence:theoptimalsurfaceinthe
positive standard deviation (sd) half of 3D space bears a homothetic property from
whateverstandpointoneassumes.Slicingthesurfacebyasequenceofplanesparallelto
thetwoodd-momentsaxeswillgenerateasequenceofcurvesstartingattheoriginand
whoseexpansionratiowillbeequaltothatoftherespective(constant)variancevalues.
Of course, slicing it by planes parallel to the sd and (standardised) skewness axes will

1
SeetheAppendixforafurtherexplanationonthenotationused.
2
Weshall,fromnowon,usetheangularcoefficientktonamethecorrespondingline/directioninthefirst
quadrantoftheRxy
3
plane.
produce a sequence of homothetic curves whose expansion ratio will be that of the
(excess) returns associated to each plan. Finally, inspection of formula (4) easily
convinces that for the last combination, i.e. planes parallel to the sd and mean returns
axes, the same will apply, as Proposition 1 is also true if the role of returns and
skewnessarereversed.
Thepropositionbelowisadirectconsequenceofthisimportantfact:

Proposition2:Foragivenlevelofy
2
(orR,ory
3
),cuttheoptimalsurfacewithaplane
orthogonal to the sd (or returns, or standardised skewness) axis and project the
intersectioncurveinthereturnsxskewness(orsdxskewness,orreturnsxsd)plane,
THEN
iftheyexist,thedirectionsintheRxy
3
(ory
2
xy
3
,orRxy
2
)halfplanerelatedtothe
highestandlowestvalue,ineachaxis,ofthecurveareinvariantwithy
2
(orR,ory
3
).

The qualification if they exist is important as, specially in the case of cuts
paralleltothesdaxis,atleastpartofthecurvemaygotoinfinity.Forconstantvariance
cuts, it may be shown that closed curves will be produced
4
. Indeed, for this case, the
highestandlowestdirectionsareparticularlynoteworthy,asdemonstratedby

Proposition3:ThedirectionintheRxy
3
halfplanethatgivesthehighestRforallthe
minimumvarianceportfolioswiththesamestandarddeviationy
2
isuniqueandrelated
to the celebrated (Markowitzs) Capital Market Line (CML). Moreover, in this
direction, the skewness constraint to programme (1) is not binding. As regards

3
Thevariableustandsforthecoordinatesalongtheaxisdefinedbythedirectionk.
4
Theproofisrathertechnicaltobeincludedinthistext.
skewness, though there may be more than one highest (and lowest) direction, the
constraintpropertyalsoapplies.

This means that the unique solution to the minimum variance portfolio, for a
givenmeanreturn:
x M
A
R
1
2
0

= ,(5)
that defines the famous Capital Market Line in mean x variance space, relating the
optimalvariancetothegivenR,
0
2
2
A
R
R
= ,(6)
also defines the (unique) direction that will pass through all the points, in each curve,
yielding the maximum mean return. In other words, in the R x y
3
half plane, this
direction is the geometric locus of all the tangency points between each (projected)
curveandastraightline,paralleltotheskewnessaxis,whichcutsthemeanreturnaxis
inthemaximummeanreturnportfoliovaluerelatedtothesetvariance(thatdefinesthe
cut). This last statement is ensured by the well-known duality result in Markowitz
world.
Skewnesses-andak-canalsobeassociatedtotheseoptimalportfolios,being
evident that they are independent of the given y
2
. It can be proved that the k the
angularcoefficientofthelinerelatedtotheextrememeanswillbeequalto:
0
3
3
,
) ( 3
A
w w M w
R
y
k
R
R

= = ,where x M w
1
2

= . (7)
Hence,k
R
isindeedaninvariantandallmaximummeanreturnsforgivenvarianceslie
inthesamedirectioninmeanxskewnessspace.
Contrary to the previous, mean returns case, the optimal weights for the
skewness extremes are implicitly defined by a non-linear system like (2). When
1
3
=
p
,wehaveasolutionportfolio
s
suchthat:
) (
1
3
1
2
4
S S s
M M
A
=

.(8)
Thehomothecyimpliesthat
3 3
3
s
s
s
s s
y = = isasolutionto(2),ensuingan
optimalvariance
2
) (
3 2 2
s s s
y = .Acorresponding(excess)returnandadirection,both
independentofthevariancelevel,canbefoundas:

3
p
s s
y R R = ,
s s
R k / 1 = ,(9)
implyingthatalltheseoptimalportfolioslieinthesamedirection.
Combining both results gives a rectangular envelope that circumscribes, in the
first quadrant of the mean x skewness plane, the corresponding part of the constant
variancecurve.

2.2.Theminimumkurtosiscase.
Theinitialstepnowisminimisingkurtosisforagivenskewnessandexpectedreturn:

Min

[ ] 3
, , , ,
4 1 3
( ) [ ( ) ( (1 1 ) )] ( ( ))
p f
p
M E r M r M + + + .(10)

Thefirstorderconditionsare:

4 3
4 ( ) 3 ( ) M x M = +
[ ]
, ,
1
( ) ( 1 )
p f f
R E r r M r x = = = (11)
3
,
3
( )
p
M =

Defining
[ ]
1
,
( 2) 4
( ) B x M I x

= ,
[ ]
1
,
0 4 3
( ) ( ) B x M I M

= and
[ ]
1 , ,
2 3 4 3
( ) ( ) ( ) B M M I M

= ,
with the subscripts chosen according to the degree of homogeneity of the term with
respecttothevector,onecanfindthevaluesofandandarriveatthenon-linear
systemthatcharacterisesthesolutionto(10):

3 3
2 0 ( 2) 0
4 3 2 2
( 2) 2 0 ( 2) 2 0
( ) ( )
( ) ( )
p p
B R B B B R
M x M
B B B B B B

= +

.(12)

Theoptimalkurtosiswillbegivenby:

3 3
4
2 2
2 0 ( 2)
2
( 2) 2 0
2 ( )
( )
p p
p
B R B R B
B B B

+
=

.(13)

Noticing that B
(-2)
and B
2
are positive, because the matrix in their middleis the
inverse of a positive definite matrix, it can be proved that both the numerator and the
denominatoroftheexpressionabovearepositive.
It is important to remark the similarities between the pairs offormulas (2)-(12)
and(4)-(13),astheyareattheheartofthesimilardevelopmentsthatfollow.Thefirstis
akeyproposition,closetoProposition1:

Proposition1*: Foragivenk,alltheminimumkurtosisportfoliosrelatedtoexpected
returns, skewnesses pairs (R,
3
p
) such that
3 3
3
R k
p
= , or kR y =
3
, are given by
R = , where defines
4
p
,the(minimum)kurtosis oftheoptimalportfoliowhen
R=1and k y =
3
.Moreover,theminimumkurtosisforanypairofconstraintsinthek-
linewillbe
4 4
4
p p
R = ,or R y y
p p
4 4
= .

The consequence of the above proposition is that exactly the same homothecy
appliesin3Dspacedefinedbythestandardisedkurtosisaxisandthetwoodd-moments
axes. The results in Proposition 2 are then easily translated to the present context and
thefollowingisvalidaswell:

Proposition3*:ThedirectionintheRxy
3
halfplanethatgivesthehighestRforallthe
minimum kurtosis portfolios with the same standardised kurtosis y
4
is unique.
Moreover, in this direction, the skewness constraint to programme (10) is not binding.
As regards skewness, there is at least one direction giving the maximum skewness,
wheretheconstraintpropertyapplies.

Thesolutiontotheproblemofminimisingkurtosisforagivenexcessreturnis:

4
( 2)
( )
R R R
R
M x
B

= ,(14)

which,whenR=1,becomes:
4
( 2)
1
( )
R R R
M x
B

= .(15)

The systems of weights defined by R

R R
= are solutions to (12); thus one
only needs to find one portfolio
R
to generate the whole set of minimum kurtosis
portfoliosforagivenR.Theskewnesscorrespondingto
R
isgivenby:
3
3 0 0
( 2) ( 2)
R
B R B
R
B B

= = ;(16)
sothattheangularcoefficient
1/ 3
0
( 2)
R
B
k
B

| |
=
|
|
\ .
(17)
defines a direction in the expected returns x skewness plane which is the maximum
meanreturnslineforagiven(minimum)kurtosis.
The maximum mean returns line divides the minimum iso-kurtosis curves in
two parts; since agents want the highest possible skewness, they will probably work
withtheupperhalfofthecurve.Incontrasttotheclassicalcaseofminimisingvariance
foragivenreturn,thereisnoclosedformfortheportfolioweights
R
,ascanbeseen
from (15). However, it is possible to show that this function is strictly convex in its
entiredomain,thereforeimplyingthatthesolutionisunique.
The highest/lowest skewness directions, as in the case of variance, will be the
onesassociatedtothesolutionoftheproblemoffindingthelowestkurtosissubjecttoa
givenskewness.Callingtheseportfolios
s
,theyareimplicitlydefinedbysystem

[ ]
3
4 3
2
( )
s
s s s s s
M M
B

= ,(18)

theportfoliothatsolvestheproblemwhen 1
3
=
p
isnaturallydefinedby:
[ ]
4 3
2
1
( )
s s s s s
M M
B
= .(19)

Itcanalsobeeasilyverifiedthatthemeanreturnrelatedtothesolutionof(18)is
3
0
2
s
R B
B

= , (20)
sothatthedirectionsaredefinedby
3 / 1
2
0

|
|
.
|

\
|
=
B
B
k
s
.(21)
Unfortunately, in this case, there can be more than one solution, and
consequentlymorethanonedirectionwithalocalmaximumskewnessforagivenlevel
of kurtosis. Notwithstanding, the projection of each iso-kurtosis curve will also be
enveloped,inthefirstquadrant,bythetwoaxesandtwotangentlinesparalleltothem.

3. Generalisingforhigherevenmoments.

We now consider the general case of minimising an even moment given the two first
oddmoments.Thelagrangianoftheproblemwillbe:

3
, ( 1) , , 2
3
( ) ( )
p
p
p
M R x M

+ + ,(22)
givingthefirstorderconditions:
( 1) 2
3
3
p
p
pM x M

= +
,
R x = (23)
3
, 2
3
p
M

= .
Noticing that
( 1) ( 2)
( )
p p
p p n
M M I

= , and that matrix
( 2)
( )
p
p n
M I

is
symmetricandpositivedefinite,thefollowingsystemcanbeformedfrom(23)togive
thevaluesofthemultipliers:

( 2) 1 ( 2) 2
3
'( ) 3 '( )
p p
p n p n
pR x M I x x M I M

= +
3
2 ( 2) 1 2 ( 2) 2
3 3 3
( ) '( ) 3 ( ) '( )
p p
p n p n
p
p M M I x M M I M

= + .(24)

Defining
1
, ( 2)
2
( )
p
p p n
B x M I x

( =

,
1
, ( 2) 2
4 3
( )
p
p p n
B x M I M

( =

and
1
, 2 , ( 2) 2
6 3 3
( ) ( )
p
p p n
B M M I M

( =

,
withthesubscriptscorrespondingtothegeneraliseddegreeofhomogeneitywithrespect
tothevectorofweights,thefinalsolutioncomesfromthesystem:

3 3
2 ( 1) 2
2 6 4 6 4 4 2 3
( ) ( ) ( )
p
p p p p p p p p
p p
B B B M B R B x B R B M


= + ;(25)

theoptimalportfoliop-thmomentbeing:

3 3
2 2
6 4 2
2
2 6 4
2 ( )
p
p p p
p p
p
p p p
B R B R B
B B B

+
=

.(26)

Again,thesimilarities(2)-(12)-(25)and(4)-(13)-(26)shouldbestressed.
Thefollowingresultsummarisesallthepropertiesofthesolutionsset:

Theorem:Foragivenp=2,4,...,considerin(R,y
3
,y
p
)spaceofstandardisedmomentsa
iso-p-thmomentcurveofsolutionsto(22)
THEN
i) the optimal portfolios set is contained in the cone {O} , where O=(0,0,0) is
theoriginof(R,y
3
,y
p
)space;
ii) theprojectionofintheRxy
3
planeisacurve:a)symmetrictotheoriginandb)
inscribed in a rectangle whose sides are parallel to the axes; the vertical and
horizontal sides correspond, resp., to the highest (and lowest) R and y
3
values
whichproduceasolutionin.

Proof(weoutlinethestepsoftheproof):Forprovingi)onefirstfollowsstepssimilar
tothoseinPropositions1and1*,showingthatoneachlinepassingthroughtheorigin
anda general point (R,y
3
), the solutions to (22) increase linearly either with R if the
solution to (1, y
3
/R) is taken as the fundamental one or with y
3
if the solution to
(R/y
3
, 1) is the one fixed. As the origin O=(0,0,0) solves (22), this is sufficient to
demonstratethatanysolutionwillbeinthecone.Inthecaseofii),thesymmetryisseen
by the fact that reverting to the pair (-R,-y
3
) does not change either (25) or (26). As
regardsthetangents,areasoningsimilartotheonesintheprevioussectiondetermines
thepointsrelativetothehighestRandy
3,
bysymmetrythepointsofthelowestRandy
3
areobtainedandtherectanglecanbetraced.

This basic result isimportant infinding the efficient portfolios set for the three
moments at stake. It is easy to convince oneself that not all points in the cone will
characteriseanefficientportfolio,though,ofcourse,theefficientsetwillbecontained
inthecone(seeAthaydeandFlres(2001)).Moreover,onecouldbetemptedtoderive
thefollowing

(false)Corollary:Ifproblem(22)hasasolutionTHENtheoptimalvalueisunique.

Indeed,bytheTheorem,if(22)hasasolutionthentheoptimalp-thmomentsmustliein
the cone. They will be found in the intersection of a vertical line through the point
definedbythegivenoddmomentsintheRxy
3
planeandthecone.Simplepropertiesof
aconeinfinitedimensionalEuclidianspacesensurethatthisintersectionisunique.
Thisnicepropertywouldmeanthatknowledgeofthegeometricstructureofthe
optimalportfoliossethadallowedasimpleandelegantproofofuniqueness.However,
such an argument would be circular, as the curve used to characterise the cone is
supposedly the curve formed already by the minimum p-th moments, related to the
optimalsolutionsof(25).Itisworthremindingthatsystem(25),asitsspecialcases(2)
and (12), implicitly defines the optimal weights, and may as well have more than one
solution. These others either will be local, not global optima or it might even happen
that different optimal vectors yield the same optimal p-th moment in (26).
Propositions1to 3(and1*and3*) arevalidforanyofthesesolutionsthismeaning
that even different solution cones may exist; but the Theorem considers, by
hypothesis,theoptimalcone,andsotheCorollaryissenseless.Unfortunately,atthe
present stage, we do not have a general, deeper knowledge of the structure of the
solutions set. Moreover, the hypothesis also requires the existence of a solution;
rigorous conditions for guaranteeing this, as regards system (25), are still an open
question.
An interesting special case of (22) is when only a mean return restriction is
imposed, the skewness constraint being disregarded. Without much difficulty one sees
thatthefirstorderconditionsbecome:
( 1) p
p
pM x

=
,
R x = .(27)
Sothattheoptimalweightsmustsolvethesystem

( 1)
2
( )
p
p p
B M Rx

= ;(28)

and the corresponding p-th moment bears the following relationship with the given
return:

1
2 2
( )
p
p
p
B
R

= .(29)
In this case, the homothecy property implies that only one system needs to be solved,
namely,theoneobtainedbysettingR=1in(28).

4. Furtherpropertiesandextensions.

Inordertogiveafurtherinsightbothonthegeometricaspectsdiscussedaswellason
thedifficultiesinvolvedinthesolutionofsystem(28),weconsiderthespecialproblem
of minimising kurtosis given expected return, in the case of two assets and setting to
zeroallco-kurtoseswhereanassetappearsonlyonce.Thisleavesuswiththreedistinct
non-zeroelementsinthekurtosistensor,andtheM
4
matrixshown,inthegeneralcase,
intheAppendixbecomes:

1 12 12 12
12 12 12 2
0 0 0 0
0 0 0 0


(
(

.

The simplified notation used for the subscripts, suppressing repetition of identical
indexes,stressestheidenticalvaluesandshouldcausenoconfusion.Noticethat,unless
theassetsdistributionsaresingular,allentriesarestrictlypositive.
Calling=(
1
,
2
)thevectorofweights,andnoticingthat:
i)
3 2
3 1 1 1 2 12
4
2 3
1 2 12 2 2
3
3
M

( +
=
(
+

;
ii)matrix
1
2
4 2
( ) M I

(

willbeequalto:

2 2
1 1 12 2 2 1 2 12
2 2
1 2 12 1 1 2 12
2
2

( +

(
+

where
4 2 2 2 4
1 1 12 1 2 1 2 12 2 12 2
( 3 ) = + + is the determinant of the direct
matrix;
oneisreadytobuildupsystem(28).Ofcourse,assaidintheprevioussection,onlyone
solution matters, namely that which considers R=1. We shall, however, impose the
additional assumptions that the marginal kurtoses are equal (i.e.,
1
=
2
=) and that
excess returnsfor both assetsarealso equal (toa common valuex). With this, we can
finallywritesystem(30):

5 2 4 3 2 2 2 3 2 4 2
1 12 1 2 12 1 2 12 12 1 2 12 1 2 12
4 2 2 2 2 4
1 12 1 2 12 2 12
[ ( 2 ) 4 (3 7 ) 12 3 ]
( 3 )
x

+ + + + =
= + +

4 2 3 2 2 2 3 2 2 4 5
1 2 12 12 1 2 12 1 2 12 12 1 2 12 2 12
4 2 2 2 2 4
1 12 1 2 12 2 12
[3 (2 ) 12 (3 2 ) 4 ]
( 3 )
x

+ + + + + =
= + +

Given the symmetry of the parameter values, the optimal weights will be
identical,beingeasytoseethattheircommonvalueis:
x 2
1
= .(31)
These weights, however, can be related to either maxima or minima. For the
latter,theborderedHessiansufficientcondition
5
amounts,inthiscase,tocheckwhether
matrix
(
(
(

+
+
0
) ( 12 24
24 ) ( 12
12
2
12
2
12
2
12
2
x x
x
x


(32)
hasanegativedeterminant.Replacingbyitsvaluein(31),theconditionbecomes:
< <
12 12
0 ) ( 6 or .(33)
The symmetric weights solution produces a minimum only if the non-null co-
kurtosisissmallerthanthecommonmarginalkurtosis.
Thisrathersimpleexamplemayserveasanillustrationofhowfarintuitioncan
help when considering higher moments, as well as of the impact of simplifications in
thehigher-momentstensors.Thefinalsolutionisindependentofthemarginalkurtoses
andoftheevenco-kurtosis.Indeed,astheriskmeasureshaveacompletelysymmetric
structureasregards thetwo(risky) assets,theidenticalweightscanbefoundbydirect
solution of the excess return constraint. The higher the identical return, obviously the
lesswillbepurchasedofeachriskyassetastheportfolioexcessreturnisfixedin1
andmorewillbeputintherisklessasset
6
.
Given the similar roles played by kurtosis and variance, we could then expect
that the same would apply for the identical weights that result when equal marginal
variancesareusedinsteadofkurtosis.Infact,(31)isexactlythesolutionto (5)inthis
case,the(common)variancesandco-variancesplayingnoroleatall.Moreover,useof
theborderedHessianconditionshowsthataminimumexistsonlyif
<
12
.(34)
Thoughidenticalto(33),(34)willbealwaysvalidiftheassetscovarianceisnegative,
what cannot happen in the case of the even co-kurtosis. Indeed, in our simplified
kurtosiscontext,thereisnoroomfordiversification.
Absentfrom(31)initstwoversions/solutions-,theriskmeasuresdohowever
playarole.Beyonddeterminingwhetheraminimumhasbeenachieved,theyexplicitly

5
See,forinstance,Theorem9.9,page202,inPanik(1976).
6
Asymptotically,alltheweightwillgototherisklessasset.
appear in the shadow price of the restrictions, given by the value of the Lagrange
multipliers.Theseareequalto
2
12
2x

+
= inthevariancecase,andto
2
12
2x

+
=
in that of kurtosis
7
. The formal identity of the two values hides different behaviours.
Again, in the case of the second moment, a negative covariance may substantially
decreasethecostoftheunitreturnrestriction.Ontheotherhand,both(nonnegative)
kurtosesaddup,penalisingmoreheavilyanincreaseinthefixedreturn.
Summing up, the example shows that the choice to minimise either kurtosis or
variance (in this very simple, symmetric case) has, in spite of producing exactly the
samesolutionweights,fairlydifferentimplications.Moreover,radicalsimplificationsin
the moments tensor may produce rather particular solutions. A small change in the
example, like allowing for different marginal kurtoses, would completely alter the
abovediscussion.Informallyspeaking,introducinghighermomentsinportfoliochoice
makesitamorenon-linearproblemand,consequently,muchmoresensibletosmall
changesintheinitialconditions.

5. Concludingremarks.

The availability of a general method to treat portfolio choice in a higher

moments context seems an unquestionable advantage. We outlined in the previous
sectionsonesuchmethod,thatallowsforacompact,analyticaltreatmentofallformulas
involvedintheoptimisationproblem.Thankstothis,powerfulgeometricinsightscould
begained.
Nevertheless, the task before anyone interested in the subject is still nearly
formidable. A basic existence result and more insights on the solutions set would be
welcome. Final characterisation of the efficient portfolios set requires more than the
techniques here discussed, duality methods being needed to completely identify the
efficient points. We solved this up to the fourth moment, Athayde and Flres (2001,
2002), but a general method seems possible. Moving from static to dynamic
optimisation frameworks generates additional, rather difficult theoretical and
computationalproblems
8
.

7
Thereadershouldkeepinmindthatbothand
12
havedifferentmeaningsinthetwoformulas.
8
WorkinthisdirectionhasbeeninitiatedwithBerRustem(ImperialCollege,London).
Last,butnotleast,assection4glimpsedinto,thenumberofdifferentsituations
inthehighermomentscaseisextremelylarge,agreatprobabilityexistingofsenseless
or unattractive special formulations. These can only be sorted out through a
combination of more theoretical findings with several examples and applied
experiments. The notation developed, and its corresponding algebra, may help in
designingmanyoftheseexperiments.

Appendix:Thematrixnotationforthehighermomentsarrays.

Dealingwithhighermomentscaneasilybecomealgebraicallycumbersome.Givenan-
dimensional random vector, the set of its p-th order moments is, as a mathematical
object,atensor.Thesecondmomentstensoristhepopularnxncovariancematrix,while
the third moments one can be visualised as a nxnxn cube in three-dimensional space.
However,thetensornotation,whichissousefulinphysics,geometryandsomeareasof
statistics (see, for instance, McCullagh (1987)), did not appear so convenient to deal
withtheportfoliochoiceproblem.Wethendevelopedaspecialnotation,whichallows
performing all the needed operations within the realm of matrix calculus. The
advantages of this are manifold. Beyond having a synthetic way to treat complicated
expressions, the mathematical tools required are standard linear algebra results and,
withthehelpofEulerstheoremasmostrealfunctionsinvolvedarehomogeneousin
the vector of portfolio weights -, a differential calculus easily ensues. Moreover, the
differentformulaeand systems arrived atare written inacompactand straightforward
way,easilytranslatedintoformalprogramminglanguages.
Before presenting the notation, we remind that, throughout the paper we deal
with all the possible p-moments of a given n-dimensional random vector of asset
returns.Undoubtedly,thedifficultyinmanipulatingallthesevaluessimultaneouslyhas
been a deterrent to tackle the problem in its full generality. Thinking of skewness and
kurtosis,forinstance,therespectivethreeandfour-dimensionalcubes,whereseveral
identicalvaluesarefound,haven
3
andn
4
elements.Ofcourse,inpractice,gatheringall
thesevaluesmayquicklybecomeaformidabletask.Indeed,asanexample,thenumber
of different kurtoses is in principle
|
|
.
|

\
| +
4
3 n
, what, in the case of five assets, gives
already70valuestobecomputed.Itisthenverylikelythat,ineachpracticalproblem,
either a significant number of co-moments will be set a priori to zero or another
simplifyingassumptionwillbeused,andveryseldomonewillworkwiththefullsetof
cross moments. However, as said in the introduction, the great variety of possible
assumptionsisanextraargumentforageneraltreatmentoftheproblem.
Our notation transforms the full p-th moments tensor, with n
p
elements, into a
matrix of order nxn
p-1
obtained by slicing all bi-dimensional nxn
p-2
layers defined by
fixing one asset and then taking all the moments in which it figures at least once and
pastingthem,inthesameorder,sideways.Rowiofthematrixlayercorrespondingto
have fixed the i-th assetgives in a pre-established order all the moments in which
assets i and i appear at least once. Of course, assets must be ordered once and for all
and this order respected in the sequencing of the layers and in the numbering of the
rowsofeachlayer.Accordingly,aconformalorderingmustbechosen,andthoroughly
used,forthecombinations(withrepetitions)ofnelementsintogroupsofp-2thatdefine
thecolumnsofeachmatrixlayer.
In the case of kurtosis, for instance, two indices/variables/co-ordinates must be
heldconstant.Calling
ijkl
ageneral(co-)kurtosis,whenn=2,theresulting2x8matrix
willbe:

1111 1112 1121 1122 1211 1212 1221 1222

2111 2112 2121 2122 2211 2212 2221 2222


(
(

where,asexpected,manyentriesareidentical.
NowsupposethatavectorofweightsR
n
isgiven,andM
1
,M
2,
M
3,...
andM
p
stand for the matrices containing the expected (excess) returns, (co-)variances,
skewnesses ... and p-moments of a random vector of n assets. The mean return,
variance, skewness ... and p-th moment of the portfolio with these weights will be,
respectively:M
1
,M
2
,M
3
()...andM
p
(...)M
p

p-1

wherestandsfortheKroneckerproduct.
The above expressions provide a clue on the mentioned advantages of the
notation. The fact that the tensors were transformed into matrices allows the use of
matrix algebra and differential calculus - in all expressions and derivations, giving
waytocompactandelegantformulas.Itisimmediatetoseethat,asrealfunctionsof,
thefourexpressionsabovearehomogenousfunctionsofthesamedegreeastheorderof
the corresponding moment. This means that Eulers theorem can be easily used in the
neededderivations.
As an example, the derivative of the portfolio kurtosis with respect to the
weightswillbe:
) ( 4 )] ( [
4 4

M M =4M
4

3
.

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