The effect of downside risk reduction on UK equity portfolios included with Managed Futures Funds

a r t i c l e i n f o The concept of asymmetric risk estimation has become more widely applied in risk management in recent years with the increased use of Value-at-risk (VaR) methodologies. This paper uses the n-degree lower partial moment (LPM) models, of which VaR is a special case, to empirically analyse the effect of downside risk reduction on UK portfolio diversification and returns. Data on Managed Futures Funds are used to replicate the increasingly popular preference of investors for including hedge funds and fund-of-funds type investments in the UK equity portfolios. The result indicates, however that the potential benefits of fund diversification may deteriorate following reductions in downside risk tolerance levels. These results appear to reinforce the importance of risk (tolerance) perception, particularly downside risk, when making decisions to include Managed Futures Funds in UK equity portfolios as the empirical analysis suggests that this could negatively affect portfolio returns. Academic and practitioner interest in asymmetric risk analysis, in particular relating to the lower partial moment (thereafter, LPM) and the development of practical applications of Value-at-risk 1 (thereafter , VaR) methodologies, has greatly increased in recent years. For example, research by Danielsson, Jorgesen, Sarma, and De Vries (2006) and Hyung and de Vries (2005) have related VaR to the lower partial moments of return distributions. The initial academic interest in LPM can in fact be traced back to Markowitz (1952) seminal paper on portfolio diversification. However, due to the combination of computational costs and the success of his mean-variance framework, Markowitz's insights into the LPM were largely ignored over the subsequent 40 years. With the development of information technology and the limitations of the mean-variance framework becoming more apparent, these constraints no longer apply and hence interest in developing LPM methods has greatly increased. Even so, to date this work has tended not to focus on how the LPM can flexibly capture varying degrees of risk tolerance and their implications in respect of portfolio allocation problems, which is the primary focus of this paper. The purpose of the current paper is to first review and discuss the risk measures related to LPM, its development and the relationship to the currently used VaR model and second to empirically evaluate from a UK investor perspective the practical implications in terms of portfolio performance. The empirical evaluation of these issues from a UK investor perspective provides the first indication …