A memetic algorithm for cardinality-constrained portfolio optimization with transaction costs

• Novel memetic algorithm for optimal portfolio selection.
• Proposed framework considers transaction costs, cardinality and other real-world constraints.
• The combinatorial and the continuous optimitzation aspects of the problem are handled separately.
• Adaptation of the RAR crossover operator for an extended set encoding.
• We find that using certain regularization mechanisms results in more efficient portfolios.
• Ignoring transaction costs results in inefficient portfolios out-of-sample.

A memetic approach that combines a genetic algorithm (GA) and quadratic programming is used to address the problem of optimal portfolio selection with cardinality constraints and piecewise linear transaction costs. The framework used is an extension of the standard Markowitz mean–variance model that incorporates realistic constraints, such as upper and lower bounds for investment in individual assets and/or groups of assets, and minimum trading restrictions. The inclusion of constraints that limit the number of assets in the final portfolio and piecewise linear transaction costs transforms the selection of optimal portfolios into a mixed-integer quadratic problem, which cannot be solved by standard optimization techniques. We propose to use a genetic algorithm in which the candidate portfolios are encoded using a set representation to handle the combinatorial aspect of the optimization problem. Besides specifying which assets are included in the portfolio, this representation includes attributes that encode the trading operation (sell/hold/buy) performed when the portfolio is rebalanced. The results of this hybrid method are benchmarked against a range of investment strategies (passive management, the equally weighted portfolio, the minimum variance portfolio, optimal portfolios without cardinality constraints, ignoring transaction costs or obtained with L1 regularization) using publicly available data. The transaction costs and the cardinality constraints provide regularization mechanisms that generally improve the out-of-sample performance of the selected portfolios.

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