On Portfolio Optimization: The Benefits of Constraints in the Presence of Transaction Costs

Sammanfattning: Most studies view transaction costs and constraints separate in the mean-variance framework. As such, I evaluate the benefits of holding and turnover constraints in the presence of transaction costs on Swedish Asset Returns. In theory, the benefits should be limited when transaction costs are included in the portfolio rebalancing problem. By using the model developed by Mitchell and Braun (2003), my results indicate that there are benefits of holding constraints in the mean-variance optimization. The main issue with the long-only portfolio is its lack of diversification. The strategy allocates the majority of the investment in 15 out of 100 assets. By imposing holding constraints, the portfolio becomes more diversified while reducing turnover volume and increasing Sharpe ratio. I find that the homogenous 1/N holding constraint increases monthly Sharpe ratio performance by 50 percent over the entire sample. However, the results are not consistent over all samples and not statistically significant. Further, turnover constraints only marginally increase performance, which more likely originates from the increase in diversification.