Abstract
When identifying optimal portfolios, practitioners often impose a drawdown constraint. This constraint is even explicit in some money management contracts such as the one recently involving Merrill Lynch’ management of Unilever’s pension fund. In this setting, we provide a characterization of optimal portfolios using mean–variance analysis. In the absence of a benchmark, we find that while the constraint typically decreases the optimal portfolio’s standard deviation, the constrained optimal portfolio can be notably mean–variance inefficient. In the presence of a benchmark such as in the Merrill Lynch–Unilever contract, we find that the constraint increases the optimal portfolio’s standard deviation and tracking error volatility. Thus, the constraint negatively affects a portfolio manager’s ability to track a benchmark.
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