On Portfolio Optimization: Imposing the Right Constraints
37 Pages Posted: 2 Jun 2010 Last revised: 8 Jan 2019
Date Written: November 26, 2012
Abstract
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.
Keywords: Portfolio Optimization, Shrinkage, Mean Squared Error, Bootstrap
JEL Classification: G11
Suggested Citation: Suggested Citation
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