Optimal Portfolios without Short Sales

If it is assumed that the SingleIndex Model (SIM)

adequately describes the covariance structure of
returns, the tangency portfolio associated with risk
free rate rf , when short sales are not allowed, can
be determined as follows.

Rank stocks (from highest to lowest) by excess

return to beta,

i :=

i rf
.
i

That is,
1 2 N 1 N .
1

 Compute
2
M

Ci =

j=1

j (j rf )
2

2
1 + M

i 2

2
j=1 j

i = 1, . . . , N.
Include those stocks into the portfolio for which
i > Ci.
Suppose there are N stocks in the optimal portfolio
(N N ). The optimal portfolio weight of stock i
is
zi
xi = N , i = 1, . . . , N ,

zj
j=1

where

[
]
i i rf
zi = 2
CN ,
i
i

i = 1, . . . , N .

Example
Consider monthly returns (1996-2001) on 10 (randomly chosen) stocks from the DAX 30, which is
used as index.
Assume rf = 0.3.
Then, we get

stock
1
2
3
4
5
6
7
8
9
10

i = ii f
4.3402
2.6276
2.1572
1.3084
1.2706
1.2626
1.2352
1.1380
1.1288
0.9441

Ci
0.3254
0.7175
0.7849
1.0767
1.0928
1.1508
1.1582
1.1570
1.1550
1.1436

xi
0.3485
0.2674
0.1181
0.1265
0.0212
0.0863
0.0321
0
0
0

xshort
i
0.3586
0.2766
0.1227
0.1421
0.0245
0.1007
0.0391
-0.0013
-0.0053
-0.0577
3

 The last column of the table shows the weights of

the tangency portfolio with short sales.

What if we need the complete ecient frontier?

Although there is a simpler (and perhaps more

elegant) method (see the second paper cited below),
the ecient frontier can be worked out by evaluating
the tangency portfolio over a grid of values for the
riskfree rate, rf .

As an example, consider the monthly returns on 24

stocks from the DAX 30.

The efficient frontier from the SIM without short sales, and rf = 0.3
5

4.5

portfolio mean

3.5

tangency
portfolio

2.5

1.5

0.5

10

15

portfolio standard deviation

SIMbased frontier with and without short sales

4

3.5

portfolio mean

2.5

no short sales
2

1.5

0.5

10

12

14

16

portfolio standard deviation

 When the Common Correlation Model (CC) is used,

optimal portfolios with nonnegative weights can be
determined as follows.
Rank stocks (from highest to lowest) by excess
return to standard deviation,
i :=

i rf
.
i

That is,
1 2 N 1 N .
Thus, as all pairwise correlation coecients are
equal to , standard deviation is the relevant risk
measure.
Compute
Ci =

j rf
,
1 + (i 1) j=1 j

i = 1, . . . , N.
7

 Include those stocks into the portfolio for which

i > Ci.
Suppose there are N stocks in the optimal portfolio
(N N ). The optimal portfolio weight of stock i
is
zi
xi = N , i = 1, . . . , N ,

zj
j=1

where
[

zi =

1
i rf
CN .
(1 )i
i

Elton/Gruber/Padberg (1976). Simple Criteria for

Optimal Portfolio Selection. Journal of Finance 31,
1341-1357.
Elton/Gruber/Padberg (1978). Simple Criteria for
Optimal Portfolio Selection: Tracing Out the Ecient Frontier. Journal of Finance 33, 296-302.
8

Example (continued)
Consider the 10 DAX stocks again.
Assume rf = 0.3.
Then, we get

stock
1
2
3
4
5
6
7
8
9
10

i = ii f
0.1919
0.1806
0.1672
0.1618
0.1144
0.1015
0.0957
0.0944
0.0854
0.0789

Ci
0.0599
0.0886
0.1037
0.1131
0.1132
0.1118
0.1101
0.1085
0.1065
0.1042

xi
0.3152
0.2550
0.2265
0.1975
0.0060
0
0
0
0
0

xshort
i
0.3837
0.3158
0.2887
0.2557
0.0582
-0.0137
-0.0315
-0.0371
-0.1005
-0.1194

The last column of the table shows the weights of

the tangency portfolio with short sales.
9

CCbased frontier with and without short sales

4

3.5

portfolio mean

2.5

no short sales

1.5

0.5

10

12

14

16

portfolio standard deviation

10

SIM and CC without short sales

4

Common Correlation
Single Index
3.5

portfolio mean

2.5

1.5

10

12

14

16

portfolio standard deviation

11

SIM and CC with short sales

4

Common Correlation
Single Index
3.5

portfolio mean

2.5

1.5

0.5

portfolio standard deviation

12