The Mean-Variance Model Revisited with a Cash Account

Abstract

Fund managers usually set aside a certain amount of cash to pay for possible redemptions, and it is believed that this will affect overall fund performance. This paper examines the properties of efficient portfolios in the mean-variance framework in the presence of a cash account. We show that investors will retain a portion of their funds in cash, as long as the required return is lower than the expected return on the portfolio corresponding to the point of intersection between the traditional efficient frontier and the straight line that passes through the minimum-variance portfolio and the origin in the mean-variance plane (intersection portfolio). In addition, the portion of funds allocated to risky assets is invested in the intersection portfolio, and this investment is more efficient than the corresponding traditional efficient portfolio. Using a simulation, we illustrate that 6% to 9% of total funds are retained in the cash account if a no-short- selling constraint is imposed. Based on real data, our out-of-sample empirical results confirm the theoretical findings.