Donuts: A Picture of Optimization Applied to Fundamental Portfolios

Abstract

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.