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FRM Part II · FRM Exam Part II · Portfolio Construction

A risk manager imposes a no-short-sales constraint on a mean-variance optimization. Relative to the unconstrained solution, which statement is most accurate?

A no-short-sales constraint narrows the feasible set, so the constrained frontier cannot lie above the unconstrained one in sample. However, it often produces more stable, diversified weights and can reduce the impact of estimation error out of sample.

  1. AThe constrained portfolio's efficient frontier lies above the unconstrained one
  2. BThe constrained frontier cannot lie above the unconstrained frontier, but weights are often more stable and diversifiedCorrect
  3. CConstraints eliminate sensitivity to expected return estimates entirely
  4. DThe constrained portfolio always has a higher Sharpe ratio in sample

Explanation

Adding constraints shrinks the feasible set, so the in-sample frontier cannot improve and is typically weakly worse. Out of sample, constraints often reduce the effect of estimation error and yield more stable weights. They do not eliminate sensitivity.

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