Abstract
Orientation: Active portfolio managers must simultaneously maximise excess returns (over benchmarks), limit risk and observe constraints on, for example, tracking errors (TRs), betas and asset weights. Research purpose: Determining the range of possible risk and returns attainable by such constrained portfolios is of interest to active portfolio managers. Weight restrictions reduce the range of achievable returns. This work demonstrates the magnitude of these reductions. Motivation for the study: This research installs and augments an approach that ascertains the effect on a TR (active) constrained portfolio in absolute risk–return space. The effects are displayed in risk–return space, demonstrating the impact on such constraints. Research approach/design and method: A theoretical approach to plot the constant TR frontier was used. Theoretical and quantitative analytical approaches to establish changes in the constant TR frontier on a simulated (but highly stylistic) market portfolios were also employed. Main findings: Considerable reduction is observed in possible investable portfolios, even for limited asset weight restrictions. This effect is amplified if multiple restrictions are imposed simultaneously, driven by both a reduced area in risk–return space enclosed by the constant TR frontier and changes in the frontier long-axis slope. Practical/managerial implications: The change in the long-axis slope sign is also a feature of changing economic conditions, thereby acting as an early warning signal with associated ramifications for asset managers. Contribution/value add: The combined effects on active portfolio performance of TR and asset weight constraints have not been investigated and demonstrated before.
Highlights
OrientationPassive investment attempts to match the performance of certain market indices rather than attempting to outperform these through specific stock assessment and selection
Active investing is generally costlier than passive investing, and many active managers do not beat the index after expenses are accounted for
By using the stylised example set out in the section ‘Research design’, comprising domestic and foreign assets (Table 1), various constraints were placed on portfolio constituents to explore their effects on the shape of the constant tracking error (TE) frontier
Summary
OrientationPassive investment attempts to match the performance of certain market indices rather than attempting to outperform these through specific stock assessment and selection. Active investment managers invest in funds whose constituents’ worth are independently assessed, whereas their passive counterparts construct portfolios of market indices in the proportion they are held in the specific index and rebalance these proportions as the market changes. The goal of active management is to beat the market or outperform agency-determined benchmarks. Active managers must comply with strict tracking error (TE) (the variance of the difference between portfolio and benchmark returns) ceilings, where punitive penalties for non-compliance can be severe (Riccetti 2012). For these reasons, passive investing often outperforms active investments
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