Abstract
Recent (2018) evidence identifies the increased need for active managers to facilitate the exploitation of investment opportunities found in inefficient markets. Typically, active portfolios are subject to tracking error (TE) constraints. The risk-return relationship of such constrained portfolios is described by an ellipse in mean-variance space, known as the constant TE frontier. Although previous work assessed the performance of active portfolio strategies on the efficient frontier, this article uses several performance indicators to evaluate the outperformance of six active portfolio strategies over the benchmark – subject to various TE constraints – on the constant TE frontier.
Highlights
Passive managers follow a benchmark tracking strategy, using financial instruments such as Exchange Traded Funds (ETFs) (Sharpe, 1991), whereas active managers seek investment opportunities with the objective of outperforming mandated benchmarks.The competition between advocates of active and passive management has recently (2018) intensified
Increasing the tracking error (TE) expands the ellipse outward in a balloon-like fashion, Figure 5 illustrates how the Maximum Sharpe Ratio (MS) and Maximum Return (MR) portfolio strategies are monotonically increasing for every increase in TE
Greater emphasis on benchmark outperformance is required for active management
Summary
Passive managers follow a benchmark (index) tracking strategy, using financial instruments such as Exchange Traded Funds (ETFs) (Sharpe, 1991), whereas active managers seek investment opportunities with the objective of outperforming mandated benchmarks. Given the shift towards active management, the potential for this investment philosophy must first be supported by compelling evidence, proving its sustained performance advantage over passive strategies (Gilreath, 2017). TE is in widespread use within the asset management industry as it is used as an indicator, with a given level of statistical reliability, to determine whether active managers add value over a benchmark (Roll, 1992), as well as limits the risk of performance fee incentivized managers (Jorion, 2003). For the first time, an evaluation of the portfolio performance of the six portfolio strategies (maximum return, minimum variance, Jorion’s benchmark risk, maximum diversification, minimum intra-correlation and maximum Sharpe ratio) on the constant tracking error frontier.
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