The Mathematics of Financial Modelingand Investment Management

16-Port Selection Mean Var Page 506 Wednesday, February 4, 2004 1:09 PM

506 The Mathematics of Financial Modeling and Investment Management

domestic asset classes are “less” risky.^27 Exhibit 16.16 presents the com-

position of the efficient frontier when the maximum allocation to EAFE

is constrained at 10% of the portfolio. As a result of this constraint, all

the portfolios now receive an allocation of U.S. large cap equity.

Exhibit 16.17 compares the composition portfolios A′ and B′ to port-

folios A′′ and B′′ the respective equally risky portfolios that lie on the con-

strained efficient frontier. In the conservative portfolio A′′, the combined

allocation to U.S. small cap and EAFE international equity has declined to

30% (from 43.8%) and in B′′ it has fallen to 34.8% (from 57.1%). Also

now the bond allocation increases for both the portfolios.

The decline in the expected return can be used to quantify the cost

of this constraint. The conservative portfolio’s expected return fell from

9.39% to 9.20%—a decline of 19 basis points. This cost may be well

EXHIBIT 16.16 Composition of the Constrained Efficient Frontier

Maximum Allocation to EAFE International Equity = 10%

Source: Exhibit 3.13 in Frank J. Fabozzi, Francis Gupta, and Harry M. Markow-

itz, “Applying Mean-Variance,” Chapter 3 in Frank J. Fabozzi and Harry M.

Markowitz (eds.), The Theory and Practice of Investment Management (Hobo-

ken, NJ: John Wiley & Sons, 2002), p. 57.

(^27) Similarly, investors in Europe may believe that EAFE equity is “less” risky than
U.S. equity and may want to limit their exposure to U.S. asset classes.