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.
Bibliographical noteFunding Information:
This paper has benefited from the valuable comments of two anonymous referees. Baptista gratefully acknowledges a research Grant from the School of Business at The George Washington University.
Copyright 2006 Elsevier B.V., All rights reserved.
- Maximum drawdown
- Portfolio selection
- Risk management