Practical Applications of Donuts: A Picture of Optimization Applied to Fundamental Portfolios

Practical Applications Summary

In Donuts: A Picture of Optimization Applied to Fundamental Portfolios, published in the Winter 2018 issue of The Journal of Portfolio Management, Ian Domowitz and Ameya Moghe (both of ITG Inc.), analyze the implications of constructing two-part portfolios consisting of an actively managed component for generating alpha and a passive component determined by a quantitative optimization process. A key aspect of their analysis is considering the effects on performance of transaction costs from active management and periodic rebalancing of a portfolio's active and passive components. They also consider the effect of portfolio size on overall transaction costs.

The authors use the metaphor of a donut to describe the design of their two-component portfolios. The hole in the center of the donut corresponds to the actively managed component, and the donut corresponds to the passive quantitatively optimized component.