Bridge over ocean
1 March 2016 Financial Analysts Journal Volume 72, Issue 2

The Impact of Constraints on Minimum-Variance Portfolios

  1. Tzee-Man Chow
  2. Engin Kose
  3. Feifei Li

Optimized minimum-variance strategies tend to have low liquidity; high turnover; high tracking error; and concentrated stock, sector, and country positions. Minimum-variance index providers typically mitigate these implementation problems by imposing constraints. The authors construct minimum-variance portfolios for the United States, global developed markets, and emerging markets and apply commonly used constraints to determine their effect on simulated portfolio characteristics, performance, and trading costs. The constraints they test succeed in improving investability but shift portfolio characteristics toward those of the capitalization-weighted benchmark. In particular, each additional constraint increases volatility. Nonetheless, minimum-variance strategies are a valid choice for risk-averse investors.

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