Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps

Ravi Jagannathan, Tongshu Ma

Research output: Contribution to journalReview articlepeer-review

580 Scopus citations

Abstract

Green and Hollifield (1992) argue that the presence of a dominant factor would result in extreme negative weights in mean-variance efficient portfolios even in the absence of estimation errors. In that case, imposing no-short-sale constraints should hurt, whereas empirical evidence is often to the contrary. We reconcile this apparent contradiction. We explain why constraining portfolio weights to be nonnegative can reduce the risk in estimated optimal portfolios even when the constraints are wrong. Surprisingly, with no-short-sale constraints in place, the sample covariance matrix performs as well as covariance matrix estimates based on factor models, shrinkage estimators, and daily data.

Original languageEnglish (US)
Pages (from-to)1651-1684
Number of pages34
JournalJournal of Finance
Volume58
Issue number4
DOIs
StatePublished - Aug 2003

ASJC Scopus subject areas

  • Accounting
  • Finance
  • Economics and Econometrics

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