Specification of Constraints in Managed Volatility Strategies

9/30/2012

Careful specification of portfolio constraints is essential in achieving an optimal minimum variance portfolio.

Specification of Constraints in Managed Volatility Strategies
		Many institutional managers and index providers have recently launched strategies to exploit the low-volatility anomaly. However, the benchmark-relative orientation of institutional mandates often results in portfolios having characteristics that closely resemble the capitalization-weighted benchmark. Overly strict portfolio constraints can prove sub-optimal by preventing the low-volatility anomaly from being fully exploited, while unconstrained portfolios may also prove sub-optimal due to the influence of estimation error in risk forecasts. This paper addresses the impact of position size and turnover constraints on Sharpe ratio in minimum variance portfolios and determines that a desirable range of constraints exist in each case.