Active Portfolio Management With Cardinality Constraints: An Application Of Particle Swarm Optimization

This paper considers the task of forming a portfolio of assets that outperforms a benchmark index, while imposing a constraint on the tracking error volatility. We examine three alternative formulations of active portfolio management. The first one is a typical setup in which the fund manager myopically maximizes excess return. The second formulation is an attempt to set a limit on the total risk exposure of the portfolio by adding a constraint that forcesa priorithe risk of the portfolio to be equal to the benchmark's. In this paper, we also propose a third formulation that directly maximizes the efficiency of active portfolios, while setting a limit on the maximum tracking error variance. In determining optimal active portfolios, we incorporate additional constraints on the optimization problem, such as a limit on the maximum number of assets included in the portfolio (i.e. the cardinality of the portfolio) as well as upper and lower bounds on asset weights. From a computational point of view, the incorporation of these complex, though realistic, constraints becomes a challenge for traditional numerical optimization methods, especially when one has to assemble a portfolio from a big universe of assets. To deal properly with the complexity and the "roughness" of the solution space, we use particle swarm optimization, a population-based evolutionary technique. As an empirical application of the methodology, we select portfolios of different cardinality that actively reproduce the performance of the FTSE/ATHEX 20 Index of the Athens Stock Exchange. Our empirical study reveals important results concerning the efficiency of common practices in active portfolio management and the incorporation of cardinality constraints.