Portfolio selection with a drawdown constraint

Gordon J. Alexander, Alexandre M. Baptista

Research output: Contribution to journalArticle

37 Citations (Scopus)

Abstract

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.

Original languageEnglish (US)
Pages (from-to)3171-3189
Number of pages19
JournalJournal of Banking and Finance
Volume30
Issue number11
DOIs
StatePublished - Nov 1 2006

Fingerprint

Portfolio selection
Optimal portfolio
Benchmark
Standard deviation
Money management
Tracking error
Managers
Mean-variance
Mean-variance analysis
Pension funds

Keywords

  • Maximum drawdown
  • Portfolio selection
  • Risk management

Cite this

Portfolio selection with a drawdown constraint. / Alexander, Gordon J.; Baptista, Alexandre M.

In: Journal of Banking and Finance, Vol. 30, No. 11, 01.11.2006, p. 3171-3189.

Research output: Contribution to journalArticle

Alexander, Gordon J. ; Baptista, Alexandre M. / Portfolio selection with a drawdown constraint. In: Journal of Banking and Finance. 2006 ; Vol. 30, No. 11. pp. 3171-3189.
@article{1276260d28e84686b8d53579f12154e6,
title = "Portfolio selection with a drawdown constraint",
abstract = "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.",
keywords = "Maximum drawdown, Portfolio selection, Risk management",
author = "Alexander, {Gordon J.} and Baptista, {Alexandre M.}",
year = "2006",
month = "11",
day = "1",
doi = "10.1016/j.jbankfin.2005.12.006",
language = "English (US)",
volume = "30",
pages = "3171--3189",
journal = "Journal of Banking and Finance",
issn = "0378-4266",
publisher = "Elsevier",
number = "11",

}

TY - JOUR

T1 - Portfolio selection with a drawdown constraint

AU - Alexander, Gordon J.

AU - Baptista, Alexandre M.

PY - 2006/11/1

Y1 - 2006/11/1

N2 - 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.

AB - 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.

KW - Maximum drawdown

KW - Portfolio selection

KW - Risk management

UR - http://www.scopus.com/inward/record.url?scp=33749663283&partnerID=8YFLogxK

UR - http://www.scopus.com/inward/citedby.url?scp=33749663283&partnerID=8YFLogxK

U2 - 10.1016/j.jbankfin.2005.12.006

DO - 10.1016/j.jbankfin.2005.12.006

M3 - Article

AN - SCOPUS:33749663283

VL - 30

SP - 3171

EP - 3189

JO - Journal of Banking and Finance

JF - Journal of Banking and Finance

SN - 0378-4266

IS - 11

ER -