Portfolio Selection With a Drawdown Constraint
Author | : Gordon J. Alexander |
Publisher | : |
Total Pages | : |
Release | : 2007 |
ISBN-10 | : OCLC:1291190567 |
ISBN-13 | : |
Rating | : 4/5 (67 Downloads) |
Book excerpt: When identifying optimal portfolios, practitioners often impose a drawdown constraint. This constraint is even explicit in some money management contracts such as the one recently involving Merrill Lynch' management of Unilever's pension fund. In this setting, we provide a characterization of optimal portfolios using mean-variance analysis. In the absence of a benchmark, we find that while the constraint typically decreases the optimal portfolio's standard deviation, the constrained optimal portfolio can be notably mean-variance inefficient. In the presence of a benchmark such as in the Merrill Lynch-Unilever contract, we find that the constraint increases the optimal portfolio's standard deviation and tracking error volatility. Thus, the constraint negatively affects a portfolio manager's ability to track a benchmark.