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Christopher D. Piros, Ph.D., CFA

Latest Revision: May 30, 2008


Despite well-known limitations, mean-variance (MV) optimization remains the

workhorse of practical asset allocation. Myriad extensions and alternatives have been proposed

over the years. Some have devoted fans. In general, however, the advantages of these methods

have not outweighed the additional complexity. Thus, MV remains an important part of almost

everyones toolkit.

Small changes in the inputs especially the expected returns can cause substantial

changes in the MV optimal portfolio. Frequently, a small change is sufficient to drive the optimal

portfolio from one corner solution to another. This is the Achilles heel of the MV framework.

To mitigate the impact of this hypersensitivity, Michaud (1998) introduced resampling. Instead

of a single MV optimization based on our best estimates of mean returns, resampling generates a

random sample of expected return vectors, optimizes using each vector, and averages the

resulting portfolio weights. Due to the averaging process, the resampled portfolio is much less

sensitive to small changes in our best estimate of mean returns.

Since resampled portfolios are less sensitive to initial inputs, there is less need to apply

portfolio constraints simply to tame the optimizer. There may be other reasons to apply

constraints however. For example, we may want to limit style tilts, capitalization tilts, or the mix

of domestic and international exposures. Because it utilizes separate case-by-case optimizations,

resampling cannot impose inequality constraints properly, i.e. only on the final portfolio.

Robust optimization offers an alternative way to mitigate sensitivity to inputs. Unlike

resampling, robust optimization can incorporate inequality constraints on the final portfolio.

However, robust optimization utilizes an objective function with components that are neither

linear nor quadratic in the portfolio weights. Thus, while it uses the same inputs as the MV
model expected returns and variance-covariance matrix it sacrifices the simplicity and

computational efficiency of the linear-quadratic structure.

This paper proposes a new MV optimization procedure for asset allocation. For reasons

that will become clear below, we refer to it as Estimation Error Perturbation (EEP). This new

method has the following advantages:

Imposes inequality constraints only on the final portfolio.

Requires only a single MV optimization. Solves all cases simultaneously.
Requires only a small number (2N+1) of cases rather than hundreds of sample points.
Cases are guaranteed to span the confidence region.
Cases reflect exactly the specified precision and correlation of estimation errors.
Preserves the Linear-Quadratic structure of optimization.

The first five of these advantages clearly differentiate EEP from resampling. As noted

above, resampling cannot impose inequality constraints on only the final portfolio. As

demonstrated below, the two methods yield quite distinct results in the presence of inequality

constraints. Whereas resampling relies on randomly generated inputs and separate optimizations,

EEP requires only a single optimization using carefully constructed, non-random inputs. EEP

uses only a small number of cases that, by construction, span the confidence region and exactly

match the specified precision and correlation of estimation errors. In contrast, resampling relies

on brute force simulation and therefore requires a much larger sample to ensure even

approximate matching of the estimation error distribution.

Construction of EEP Cases

In order to impose inequality constraints on only the final portfolio, we must solve all

cases simultaneously. Hence, it is important that our method require only a small set of cases.

Generating random inputs by brute force will not suffice for this purpose. Instead, we construct

non-random cases that exactly match the specified precision and correlation structure of the

estimation errors.


vector of point estimates for expected returns

variance-covariance matrix of estimation errors for expected returns
S Diagonal matrix of estimation error standard deviations
C Correlation matrix of estimation errors
Diagonal matrix of eigenvalues of C
P Matrix of eigenvectors of C (a.k.a. Principal Components)
N Number of assets

We want to create a set of expected return vectors such that the variance-covariance matrix of the

cases is exactly and the cases span the corresponding N-dimensional confidence region. By

assumption, and C, are positive definite. Hence, we can decompose as


Now define
X = SP 2 N

Each column of X is one observation vector for estimation errors on the N asset class expected

returns. By construction

1 XX T =

Note that X corresponds to perturbing a set of independent, standard Normal factors one at a

time. Each factor is perturbed by the square root of N times the square of one of the eigenvalues

of C. Each of these perturbations is positive since is positive definite. To incorporate the other

side of the confidence interval we use both X and X. Thus, we have (2N+1) cases

corresponding to and +/- X.

Exhibit 1 illustrates the EEP cases when there are two asset classes, i.e. N=2. Four of the

five cases lie on the boundary of the elliptical confidence region, one at each end of the two

orthogonal axises. The fifth case lying at the center of the region is the central point estimate of

expected returns, i.e. . Similarly, with N-assets the cases span an N-dimensional ellipsoid

centered on .

Exhibit 1: Perturbation in Two Dimensions

The Simultaneous Optimization

The single-case optimization problem is

Max T T V

a eq = beq
s.t. a ie bie
lb ub

If there are multiple equality and inequality constraints then aeq and aie are matrices. The budget

constraint is included in the set of equality constraints.


Expected returns for all cases stacked as a [(2N2+N) x 1] column vector

Portfolio weights for all cases stacked as a [(2N2+N) x 1] column vector
= I2N+1 V
Aeq = I2N+1 aeq
Beq = I2N+1 beq
Aie = (I2N+1)T aie / (2N+1)
Lb = I2N+1 lb
Ub = I2N+1 ub

the simultaneous optimization is

Max * T * T
* *

Aeq * = Beq
s.t. Aie * Bie
Lb * Ub

The original equality constraints, e.g. the budget constraint, and the upper and lower bounds are

imposed case-by-case. The inequality constraints, however, are imposed only on the average

portfolio weights for each asset class. They are not imposed on each individual case separately.

The final EEP portfolio is obtained by averaging the portfolio weight for each asset

across the (2N+1) cases. By construction, these portfolio weights satisfy all of the original


The Impact of Inequality Constraints

Exhibit 2 illustrates the impact of imposing inequality constraints. The eight asset classes,

listed in the first column, include large and small cap Value and Growth. The last three rows of

the table summarize the total allocations to Value and Growth as well as the ratio of these


Exhibit 2: The Impact of Inequality Constraints

Single Case Case-by-Case Average

Unconstrained No Constraints Constrained EEP
R 1000 Value 0.152 0.161 0.110 0.147
R 1000 Growth 0.071 0.079 0.103 0.090
R 2000 Value 0.101 0.099 0.071 0.092
R 2000 Growth 0.030 0.065 0.084 0.069
MSCI EAFE 0.254 0.218 0.225 0.218
LB Aggregate 0.272 0.163 0.174 0.165
LB Hi-Yld 0.050 0.081 0.089 0.082
Citi Non-US (Hedged) 0.070 0.135 0.145 0.138

Value Style 0.253 0.260 0.180 0.239

Growth Style 0.101 0.144 0.187 0.159
Value/Growth Ratio 2.500 1.806 0.966 1.500

The second column of the exhibit shows the portfolio obtained from a single-case,

unconstrained optimization with inputs that generate a reasonably diversified portfolio including

all eight asset classes. This represents standard MV optimization with a well-refined set of

expected returns. As shown in the last three rows, however, this portfolio has a very substantial

Value tilt: the domestic equity allocation is roughly 71% Value and 29% Growth. In relative

terms, the Value allocation is 2.5 times the Growth allocation.

Suppose we need to limit the style tilt to at most a 1.5 ratio, i.e. a 60/40 balance between

Value and Growth. The last column of the exhibit shows that the portfolio obtained using EEP

satisfies this as a binding constraint.

The third and fourth columns show the portfolios obtained from case-by-case

optimization with and without imposing the style tilt constraint. To facilitate comparison these

portfolios utilize the 17 EEP cases. The third column ignores the constraint and hence is

analogous to the usual notion of resampling. The averaging process reduces the style tilt, but

the constraint is not satisfied. Thus, this is not an acceptable portfolio.

The fourth column imposes the inequality constraint case-by-case. This might be dubbed

resampling with constraint. While the constraint is satisfied, it is not binding and the resulting

portfolio is rather perverse: the Growth allocation is actually slightly larger than the Value

allocation despite the Value tilt inherent in our underlying views.

Why doesnt resampling with constraint satisfy the inequality as a binding constraint?

Since the constraint is imposed case-by-case, the final portfolio cannot satisfy the inequality as

an equality unless the constraint is binding for every case. Otherwise, the final portfolio is pulled

into the interior of the feasible region by the cases in which the constraint is not binding. In

effect, resampling with constraint implicitly imposes an even tighter constraint that may distort

the final portfolio. In contrast, EEP imposes exactly the specified constraint on the final portfolio

and it may be binding (non-binding) for the final portfolio even if it is non-binding (binding) for

some of the individual cases.