On Portfolio Optimization: Imposing the Right Constraints
Braziliann School of Public and Business Administration
University of Ulm - Department of Mathematics and Economics
EBS Universität für Wirtschaft und Recht - EBS Business School - Department of Finance, Accounting and Real Estate
November 26, 2012
Journal of Banking & Finance 37 (2013), 1232–1242
We reassess the recent finding that no established portfolio strategy outperforms the naively diversified portfolio, 1/N, by developing a constrained minimum-variance portfolio strategy on a shrinkage theory based framework. Our results show that our constrained minimum-variance portfolio yields significantly lower out-of-sample variances than many established minimum-variance portfolio strategies. Further, we observe that our portfolio strategy achieves higher Sharpe ratios than 1/N, amounting to an average Sharpe ratio increase of 32.5% across our six empirical datasets. We find that our constrained minimum-variance strategy is the only strategy that achieves the goal of improving the Sharpe ratio of 1/N consistently and significantly. At the same time, our developed portfolio strategy achieves a comparatively low turnover and exhibits no excessive short interest.
Number of Pages in PDF File: 37
Keywords: Portfolio Optimization, Shrinkage, Mean Squared Error, Bootstrap
JEL Classification: G11Accepted Paper Series
Date posted: June 2, 2010 ; Last revised: March 11, 2013
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