Portfolio selection with a drawdown constraint

Gordon J. Alexander, Alexandre M. Baptista

Research output: Contribution to journalArticlepeer-review

39 Scopus citations

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

Keywords

  • Maximum drawdown
  • Portfolio selection
  • Risk management

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