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Mean-Variance Optimization For Asset Allocation
Mean-Variance Optimization For Asset Allocation
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Despite well-known limitations, mean-variance (MV) optimization remains the
workhorse of practical asset allocation. Myriad extensions and alternatives have been proposed
over the years. Some have devoted fans. In general, however, the advantages of these methods
have not outweighed the additional complexity. Thus, MV remains an important part of almost
everyones toolkit.
Small changes in the inputs especially the expected returns can cause substantial
changes in the MV optimal portfolio. Frequently, a small change is sufficient to drive the optimal
portfolio from one corner solution to another. This is the Achilles heel of the MV framework.
To mitigate the impact of this hypersensitivity, Michaud (1998) introduced resampling. Instead
of a single MV optimization based on our best estimates of mean returns, resampling generates a
random sample of expected return vectors, optimizes using each vector, and averages the
resulting portfolio weights. Due to the averaging process, the resampled portfolio is much less
Since resampled portfolios are less sensitive to initial inputs, there is less need to apply
portfolio constraints simply to tame the optimizer. There may be other reasons to apply
constraints however. For example, we may want to limit style tilts, capitalization tilts, or the mix
resampling cannot impose inequality constraints properly, i.e. only on the final portfolio.
resampling, robust optimization can incorporate inequality constraints on the final portfolio.
However, robust optimization utilizes an objective function with components that are neither
linear nor quadratic in the portfolio weights. Thus, while it uses the same inputs as the MV
model expected returns and variance-covariance matrix it sacrifices the simplicity and
This paper proposes a new MV optimization procedure for asset allocation. For reasons
that will become clear below, we refer to it as Estimation Error Perturbation (EEP). This new
The first five of these advantages clearly differentiate EEP from resampling. As noted
above, resampling cannot impose inequality constraints on only the final portfolio. As
demonstrated below, the two methods yield quite distinct results in the presence of inequality
constraints. Whereas resampling relies on randomly generated inputs and separate optimizations,
EEP requires only a single optimization using carefully constructed, non-random inputs. EEP
uses only a small number of cases that, by construction, span the confidence region and exactly
match the specified precision and correlation of estimation errors. In contrast, resampling relies
on brute force simulation and therefore requires a much larger sample to ensure even
In order to impose inequality constraints on only the final portfolio, we must solve all
cases simultaneously. Hence, it is important that our method require only a small set of cases.
Generating random inputs by brute force will not suffice for this purpose. Instead, we construct
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non-random cases that exactly match the specified precision and correlation structure of the
estimation errors.
Let
We want to create a set of expected return vectors such that the variance-covariance matrix of the
cases is exactly and the cases span the corresponding N-dimensional confidence region. By
= SPP T S
Now define
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X = SP 2 N
Each column of X is one observation vector for estimation errors on the N asset class expected
returns. By construction
1 XX T =
N
Note that X corresponds to perturbing a set of independent, standard Normal factors one at a
time. Each factor is perturbed by the square root of N times the square of one of the eigenvalues
of C. Each of these perturbations is positive since is positive definite. To incorporate the other
side of the confidence interval we use both X and X. Thus, we have (2N+1) cases
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Exhibit 1 illustrates the EEP cases when there are two asset classes, i.e. N=2. Four of the
five cases lie on the boundary of the elliptical confidence region, one at each end of the two
orthogonal axises. The fifth case lying at the center of the region is the central point estimate of
expected returns, i.e. . Similarly, with N-assets the cases span an N-dimensional ellipsoid
centered on .
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Max T T V
a eq = beq
s.t. a ie bie
lb ub
If there are multiple equality and inequality constraints then aeq and aie are matrices. The budget
Letting
Max * T * T
* *
Aeq * = Beq
s.t. Aie * Bie
Lb * Ub
The original equality constraints, e.g. the budget constraint, and the upper and lower bounds are
imposed case-by-case. The inequality constraints, however, are imposed only on the average
portfolio weights for each asset class. They are not imposed on each individual case separately.
The final EEP portfolio is obtained by averaging the portfolio weight for each asset
across the (2N+1) cases. By construction, these portfolio weights satisfy all of the original
constraints.
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The Impact of Inequality Constraints
Exhibit 2 illustrates the impact of imposing inequality constraints. The eight asset classes,
listed in the first column, include large and small cap Value and Growth. The last three rows of
the table summarize the total allocations to Value and Growth as well as the ratio of these
allocations.
The second column of the exhibit shows the portfolio obtained from a single-case,
unconstrained optimization with inputs that generate a reasonably diversified portfolio including
all eight asset classes. This represents standard MV optimization with a well-refined set of
expected returns. As shown in the last three rows, however, this portfolio has a very substantial
Value tilt: the domestic equity allocation is roughly 71% Value and 29% Growth. In relative
Suppose we need to limit the style tilt to at most a 1.5 ratio, i.e. a 60/40 balance between
Value and Growth. The last column of the exhibit shows that the portfolio obtained using EEP
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The third and fourth columns show the portfolios obtained from case-by-case
optimization with and without imposing the style tilt constraint. To facilitate comparison these
portfolios utilize the 17 EEP cases. The third column ignores the constraint and hence is
analogous to the usual notion of resampling. The averaging process reduces the style tilt, but
The fourth column imposes the inequality constraint case-by-case. This might be dubbed
resampling with constraint. While the constraint is satisfied, it is not binding and the resulting
portfolio is rather perverse: the Growth allocation is actually slightly larger than the Value
Why doesnt resampling with constraint satisfy the inequality as a binding constraint?
Since the constraint is imposed case-by-case, the final portfolio cannot satisfy the inequality as
an equality unless the constraint is binding for every case. Otherwise, the final portfolio is pulled
into the interior of the feasible region by the cases in which the constraint is not binding. In
effect, resampling with constraint implicitly imposes an even tighter constraint that may distort
the final portfolio. In contrast, EEP imposes exactly the specified constraint on the final portfolio
and it may be binding (non-binding) for the final portfolio even if it is non-binding (binding) for