July  2021, 17(4): 1531-1556. doi: 10.3934/jimo.2020033

Optimizing 3-objective portfolio selection with equality constraints and analyzing the effect of varying constraints on the efficient sets

1. 

China Academy of Corporate Governance & Department of Financial Management, Business School, Nankai University, 94 Weijin Road, Tianjin 300071, China

2. 

Department of Financial Management, Business School, Nankai University, 94 Weijin Road, Tianjin 300071, China

* Corresponding author: Su Zhang

Received  May 2019 Revised  August 2019 Published  July 2021 Early access  February 2020

Fund Project: The research is supported by the National Social Science Fund of China 2018 (Grant No. 18BGL063)

Markowitz proposes portfolio selection as a 2-objective model and emphasizes computing (whole) efficient sets and nondominated sets. Computing the sets has long been a topic in multiple-objective optimization. Researchers have gradually recognized other criteria in addition to variance and expected return. To formulate the additional criteria, researchers propose multiple-objective portfolio selection. However, computing the corresponding efficient set and nondominated set is not fully achieved. Moreover, discovering the sets' properties and utilizing the properties remain typically unanswered.

In this paper, we extend Sharpe's and Merton's model by adding a general linear objective and imposing equality constraints. To optimize the model, we analytically derive the minimum-variance surface (defined later), prove it as a nondegenerate paraboloid, and prove the nondominated set as a paraboloidal segment. We also analytically derive the efficient set and prove it as a 2-dimensional translated cone. We then prove that the set subsumes the efficient set of the corresponding traditional model, so the efficient set expands as the general linear objective is added. Furthermore, constraints can be changed or added. We utilize the translated-cone properties and readily compute the changing constraints' effect on the efficient sets by formulae or linear-equation systems.

Citation: Yue Qi, Xiaolin Li, Su Zhang. Optimizing 3-objective portfolio selection with equality constraints and analyzing the effect of varying constraints on the efficient sets. Journal of Industrial and Management Optimization, 2021, 17 (4) : 1531-1556. doi: 10.3934/jimo.2020033
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show all references

References:
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V. V. Acharya and L. H. Pedersen, Asset pricing with liquidity risk, J. Financial Economics, 77 (2005), 375-410.  doi: 10.3386/w10814.

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A. Alankar, P. Blaustein and M. S. Scholes, The cost of constraints: Risk management, agency theory and asset prices, work in progress, Stanford University, Graduate School of Business, 2014. doi: 10.2139/ssrn.2337797.

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P. BehrA. Guettler and F. Truebenbach, Using industry momentum to improve portfolio performance, J. Banking & Finance, 36 (2012), 1414-1423.  doi: 10.1016/j.jbankfin.2011.12.007.

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A. Bilbao-Terol, M. Arenas-Parra, V. Cañal-Fernández and C. Bilbao-Terol, Selection of socially responsible portfolios using hedonic prices, in Operations Research Proceedings 2012, Operations Research Proceedings, Springer, Cham, 2014. doi: 10.1007/978-3-319-00795-3_8.

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[19]

G. Chow, Portfolio selection based on return, risk, and relative performance, Financial Analysts Journal, 51 (1995), 54-60.  doi: 10.2469/faj.v51.n2.1881.

[20]

T. ChowE. Kose and F. Li, The impact of constraints on minimum-variance portfolios, Financial Analysts Journal, 72 (2016), 52-70.  doi: 10.2469/faj.v72.n2.5.

[21]

V. DeMiguelL. GarlappiF. J. Nogales and R. Uppal, A generalized approach to portfolio optimization: Improving performance by constraining portfolio norms, Management Science, 55 (2009), 798-812. 

[22]

V. DeMiguelL. Garlappi and R. Uppal, Optimal versus naive diversification: How inefficient is the 1/N portfolio strategy?, Rev. Financial Studies, 22 (2009), 1915-1953.  doi: 10.1093/acprof:oso/9780199744282.003.0034.

[23]

G. DorfleitnerM. Leidl and J. Reeder, Theory of social returns in portfolio choice with application to microfinance, J. Asset Management, 13 (2012), 384-400.  doi: 10.1057/jam.2012.18.

[24]

P. H. DybvigH. K. Farnsworth and J. N. Carpenter, Portfolio performance and agency, Rev. Financial Studies, 23 (2010), 1-23.  doi: 10.1093/rfs/hhp056.

[25]

M. EhrgottK. Klamroth and C. Schwehm, An MCDM approach to portfolio optimization, European J. Oper. Res., 155 (2004), 752-770.  doi: 10.1016/S0377-2217(02)00881-0.

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F. J. FabozziS. Focardi and C. Jonas, Trends in quantitative equity management: Survey results, Quantitative Finance, 7 (2007), 115-122.  doi: 10.1080/14697680701195941.

[28]

E. F. Fama, Foundations of Finance: Portfolio Decisions and Securities Prices, Basic Books, Inc., New York, 1976. doi: 10.2307/2553407.

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E. F. Fama and K. R. French, The cross-section of expected stock returns, J. Finance, 47 (1992), 427-465.  doi: 10.1111/j.1540-6261.1992.tb04398.x.

[30]

E. F. Fama and K. R. French, International tests of a five-factor asset pricing model, J. Financial Economics, 123 (2017), 441-463.  doi: 10.1016/j.jfineco.2016.11.004.

[31]

M. A. Ferreira and P. Matos, The colors of investors' money: The role of institutional investors around the world, J. Financial Economics, 88 (2008), 499-533.  doi: 10.1016/j.jfineco.2007.07.003.

[32]

A. M. Geoffrion, Proper efficiency and the theory of vector maximization, J. Math. Anal. Appl., 22 (1968), 618-630.  doi: 10.1016/0022-247X(68)90201-1.

[33]

R. R. Grauer and F. C. Shen, Do constraints improve portfolio performance?, J. Banking & Finance, 24 (2000), 1253-1274.  doi: 10.1016/S0378-4266(99)00069-2.

[34]

J. B. Guerard and A. Mark, The optimization of efficient portfolios: The case for an R & D quadratic term, Research in Finance, 20 (2003), 217-247.  doi: 10.1016/S0196-3821(03)20011-3.

[35]

C. R. HarveyJ. C. LiechtyM. W. Liechty and P. Müller, Portfolio selection with higher moments, Quant. Finance, 10 (2010), 469-485.  doi: 10.1080/14697681003756877.

[36]

M. HirschbergerY. Qi and R. E. Steuer, Large-scale MV efficient frontier computation via a procedure of parametric quadratic programming, European J. Oper. Res., 204 (2010), 581-588.  doi: 10.1016/j.ejor.2009.11.016.

[37]

M. HirschbergerR. E. SteuerS. UtzM. Wimmer and Y. Qi, Computing the nondominated surface in tri-criterion portfolio selection, Oper. Res., 61 (2013), 169-183.  doi: 10.1287/opre.1120.1140.

[38]

C. Huang and R. H. Litzenberger, Foundations for Financial Economics, North-Holland Publishing Co., New York, 1988.

[39]

R. Jagannathan and T. Ma, Risk reduction in large portfolios: Why imposing the wrong constraints helps, J. Finance, 58 (2003), 1651-1684.  doi: 10.3386/w8922.

[40]

C. P. Jones and G. R. Jensen, Investments: Analysis and Management, John Wiley & Sons, New York, 2016.

[41]

B. D. Jordan, T. W. Miller and S. D. Dolvin, Fundamentals of Investments: Valuation and Management, McGraw-Hill Education, New York, 2015.

[42]

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Figure 1.  Major methods to solve (1) and (3) in the central and right parts, respectively
Figure 4.  The minimum-variance surface
Figure 2.  An efficient set and efficient sets under changing constraints in $ \mathbb{R}^n $
Figure 3.  The existence of many nondominated portfolios for $ z_1 = 1 $ of (4) for the proof of Theorem 4.5
Figure 5.  The nondominated set
Figure 6.  The existence of zero-covariance portfolio $ \mathbf{{z}}^{zcp} $ for (2)
Table 1.  The result of the hypotheses (24)-(27)
For (24) For (25) For (26) For (27)
mean for $ \mathbf{{x}}^e $: 0.0052 mean for $ \mathbf{{x}}^e $: 0.0022 mean for $ \mathbf{{x}}^e $: 0.0052 mean for $ \mathbf{{x}}^e $: 0.0022
mean for $ \mathbf{{x}}^n $: 0.0054 mean for $ \mathbf{{x}}^n $: 0.0020 mean for $ \mathbf{{x}}^p $: 0.0055 mean for $ \mathbf{{x}}^p $: 0.0019
p-value: 0.9585 p-value: 0.0130 p-value: 0.9268 p-value: 0.0085
accept $ H_0 $ reject $ H_0 $ accept $ H_0 $ reject $ H_0 $
For (24) For (25) For (26) For (27)
mean for $ \mathbf{{x}}^e $: 0.0052 mean for $ \mathbf{{x}}^e $: 0.0022 mean for $ \mathbf{{x}}^e $: 0.0052 mean for $ \mathbf{{x}}^e $: 0.0022
mean for $ \mathbf{{x}}^n $: 0.0054 mean for $ \mathbf{{x}}^n $: 0.0020 mean for $ \mathbf{{x}}^p $: 0.0055 mean for $ \mathbf{{x}}^p $: 0.0019
p-value: 0.9585 p-value: 0.0130 p-value: 0.9268 p-value: 0.0085
accept $ H_0 $ reject $ H_0 $ accept $ H_0 $ reject $ H_0 $
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