Thinking

Donuts: A Picture of Optimization Applied to Fundamental Portfolios

Ian Domowitz, Vice Chairman, ITG
Ameya Moghe, Vice President, ITG Analytics

The authors ask the question: How does one incorporate the benefits of portfolio optimization without disturbing the core beliefs of the fundamental manager? A solution is characterized graphically, and by example, capturing a variety of portfolio strategies. The simplicity of the framework permits the evaluation of multiple measures of portfolio performance along only two dimensions. Applied to risk reduction programs, risk-adjusted return is flat to rising across augmented portfolios, and the cost of implementing rebalancing decisions falls sharply, increasing fund capacity. The framework is applied to an evaluation of portfolios relative to new Securities and Exchange Commission liquidity-risk regulations. Risk-adjusted return increases monotonically with the degree of liquidity enhancement. Benefits increase as assets-under-management rise, consistent with greater savings in the form of implementation costs. Even marginal increases in portfolio liquidity produce appreciable improvements in risk-adjusted returns.

Fundamental managers typically do not subscribe to the gospel of mathematical optimization. A summary of remarks made by such portfolio strategists might read like the following: I have a limited number of views on the world, but can pick securities with good alpha that represent these views. If I use an optimization process in my portfolio construction, the mathematics will rearrange my priorities and even discard some views in which I strongly believe. I know that I may need diversification, given the small number of views, but I cannot let that upset my core portfolio in any way. Taking implementation costs into account exacerbates my issue, and besides, a few basis points won’t matter one way or the other.

We pose three questions related to these observations.

  • How does one incorporate the benefits of portfolio optimization without disturbing the core beliefs of the fundamental manager?
  • Can one characterize the answer in such a way as to be able to capture the variety of portfolio strategies in the market?
  • What is the role of trading transaction costs in any such solution?

Read the full report >