Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps

Posted: 22 Nov 2003

See all articles by Tongshu Ma

Tongshu Ma

Binghamton University

Ravi Jagannathan

Northwestern University - Kellogg School of Management; National Bureau of Economic Research (NBER); Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF); Indian School of Business (ISB), Hyderabad

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Abstract

Green and Hollifield (1992) argue that the presence of a dominant factor would result in extreme negative weights in mean-variance efficient portfolios even in the absence of estimation errors. In that case, imposing no-short-sale constraints should hurt, whereas empirical evidence is often to the contrary. We reconcile this apparent contradiction. We explain why constraining portfolio weights to be nonnegative can reduce the risk in estimated optimal portfolios even when the constraints are wrong. Surprisingly, with no-short-sale constraints in place, the sample covariance matrix performs as well as covariance matrix estimates based on factor models, shrinkage estimators, and daily data.

Suggested Citation

Ma, Tongshu and Jagannathan, Ravi, Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps. Journal of Finance, Vol. 58, pp. 1651-1684, August 2003. Available at SSRN: https://ssrn.com/abstract=424756

Tongshu Ma

Binghamton University ( email )

PO Box 6001
Binghamton, NY 13902-6000
United States

Ravi Jagannathan (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
429 Andersen Hall
Evanston, IL 60208
United States
847-491-8338 (Phone)
847-491-5719 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

Indian School of Business (ISB), Hyderabad ( email )

Hyderabad, Gachibowli 500 019
India

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