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- Title
Optimal Leveraged Portfolio Selection Under Quasi-Elastic Market Impact.
- Authors
Edirisinghe, Chanaka; Chen, Jingnan; Jeong, Jaehwan
- Abstract
Dangers of Ignoring Market Friction When Leveraging Financial Portfolios Portfolio leveraging is a standard industry practice to target higher fund returns, for example, in risk parity asset allocation. However, the existing models of optimal bet sizing fail to integrate analytically the impact on leveraged portfolio selection resulting from market liquidity issues. The paper "Optimal Leveraged Portfolio Selection Under Quasi-Elastic Market Impact" considers a market in which both temporary and permanent impact on trading prices are present with the former impact being sufficiently large relative to the latter. Our analytical conclusions, supported by a case study that uses even relatively more liquid U.S. exchange-traded fund assets, demonstrate that fund managers are ill advised to ignore market friction when leveraging to achieve target higher returns. Not only risk-adjusted returns significantly deteriorate, but also those losses become steeper when setting higher targets requiring increased levels of leverage. Moreover, leverage-constrained and less risk-averse investors ignoring liquidity costs ex ante face the most losses in expected utility ex post. We study optimal portfolio choice under leveraging to improve portfolio performance when trade execution faces market impact. We consider a quasi-elastic market with continuous trading in which temporary liquidity costs are sufficiently large relative to permanent impact. The resulting convex optimization model is used to show analytically that an unlevered portfolio maximizing the Sharpe ratio is no longer a tangency portfolio, and increasing the portfolio target mean leads to severely undermining the risk-adjusted returns and requiring increased portfolio leverage. This paper develops theoretical properties underlying the relationships among target mean, leverage, and Sharpe ratio in optimal portfolio selection under market impact. The Sharpe-leverage efficient frontiers under market impact are consistently dominated when setting higher return targets. Moreover, leverage-constrained and less risk-averse investors ignoring liquidity costs ex ante suffer the most losses in expected utility. Detailed computational analyses are provided using real-world data to support and highlight our analytical findings. Funding: The research of the corresponding author, J. Chen, was partially supported by the National Natural Science Foundation of China [Grants 72171012 and 11801023]. Supplemental Material: The online appendix is available at https://doi.org/10.1287/opre.2023.2462.
- Subjects
CHINA; FINANCIAL leverage; PORTFOLIO performance; INVESTORS; ASSET allocation; SHARPE ratio; EXPECTED utility; PORTFOLIO management (Investments)
- Publication
Operations Research, 2023, Vol 71, Issue 5, p1558
- ISSN
0030-364X
- Publication type
Article
- DOI
10.1287/opre.2023.2462