Abstract
Purpose Using a portfolio comprising liquid global stocks and bonds, this study aims to limit absolute risk to that of a standardised benchmark and determine whether this has a significant impact on expected return in both high volatility period (HV) and low volatility period (LV). Design/methodology/approach Using a traditional benchmark comprising 40% equity and 60% bonds, a constant tracking error (TE) frontier was constructed and implemented. Portfolio performance for different TE constraints and different economic periods (expansion and contraction) was explored. Findings Results indicate that during HV, replicating benchmark portfolio risk produces portfolios that outperform both the maximum return (MR) portfolio and the benchmark. MR portfolios outperform those with the same risk as that of the benchmark in LV. The MR portfolio weights assets to obtain the highest return on the TE frontier. During HV, the benchmark replicated risk portfolio obtained a higher absolute risk value than that of the MR portfolio because of an inefficient benchmark. In HV, the benchmark replicated risk portfolio favoured intermediate maturity treasury bills. Originality/value There is a dearth of literature exploring the performance of active portfolios subject to TE constraints. This work addresses this gap and demonstrates, for the first time, the relative portfolio performance of several standard portfolio choices on the frontier.
Highlights
Within the asset management sector, tracking error (TE) is a fundamental performance evaluation measure that has been used by the industry to ensure portfolio managers adhere to their given investment policy statement (IPS)
Conclusions and suggestions for further study Active portfolio managers are bound by TE constraints, which ignore absolute risk focusing instead on excess return optimisation, which generally increases total portfolio risk in low volatility period (LV)
Jorion (2003) showed that a TE constraint leads to an ellipse around the benchmark of attainable portfolios, given the portfolio meets the IPS
Summary
Within the asset management sector, tracking error (TE) is a fundamental performance evaluation measure that has been used by the industry to ensure portfolio managers adhere to their given investment policy statement (IPS). TE is an active risk measure that stipulates the standard deviation of the difference between the portfolio return and the benchmark return (or excess return). Portfolio managers pursue positive returns that are above the benchmark, while simultaneously adhering to mandated constraints as they have an incentive to outperform the benchmark to earn additional revenue from performance fees. Investors enforce a TE constraint, but this can result in portfolio managers focusing only on optimising excess returns and ignoring an investor’s overall portfolio risk (Roll, 1992). Many investors incorrectly believe or assume that a higher TE is associated with a higher potential return, which may not always be true (Thomas et al, 2013)
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