Decomposing the Impact of Portfolio Constraints, August 2009

This paper analyzes the impact of constraints on portfolio return and risk, extending the insights of previous research in this area. We show that constraints move a manager's portfolio away from the optimal unconstrained portfolio in two ways. First, they may rein in or increase the risk of the portfolio without impairing its information ratio. Second, they may force the portfolio to take unwanted bets that incur risk but yield no return. As a result, a constrained portfolio consists of positions that are aligned with the manager's alphas and positions that are orthogonal to the alphas but are adopted to satisfy the constraints. We illustrate how to measure the risk and return arising from each of these sources and how to drill down to examine the contributions of individual constraints