Enhanced Portfolio Optimization

Portfolio optimization should provide large benefits for investors, but standard mean–variance optimization (MVO) works so poorly in practice that optimization is often abandoned. Many of the approaches developed to address this issue are surrounded by mystique regarding how, why, and whether they really work. So, we sought to simplify, unify, and demystify optimization. We identified the portfolios that cause problems in standard MVO, and we present here a simple “enhanced portfolio optimization” method. Applying this method to industry momentum and time-series momentum across equities and global asset classes, we found significant alpha beyond the market, the 1/N portfolio, and standard asset pricing factors.Disclosure: The authors report no conflicts of interest. AQR Capital Management is a global investment management firm that may or may not apply similar investment techniques or methods of analysis as described here. The views expressed here are those of the authors and not necessarily those of AQR. Lasse Heje Pedersen gratefully acknowledges support from Center for Financial Frictions (Grant No. DNRF102). Editor’s Note: Submitted 13 August 2020Accepted 17 November 2020 by Stephen J. Brown