Investment strategy performance under tracking error constraints
-
DOIhttp://dx.doi.org/10.21511/imfi.16(1).2019.19
-
Article InfoVolume 16 2019, Issue #1, pp. 239-257
- Cited by
- 1095 Views
-
407 Downloads
This work is licensed under a
Creative Commons Attribution 4.0 International License
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.
- Keywords
-
JEL Classification (Paper profile tab)C52, G11
-
References32
-
Tables1
-
Figures10
-
- Figure 1. (a) Efficient frontier, TE frontier and constant TE frontier and (b) efficient frontier, TE frontier and constant TE frontier and capital market line (CML) in mean/standard deviation space
- Figure 2. TE frontier, constant TE frontier and portfolio strategies
- Figure 3. Intra-correlation and diversification ratio subject to a TE = %V
- Figure 4. The empirical identification of applying brute force mathematics on the MD and MIC portfolios to be constrained by TE
- Figure 5. (a) Loci of the six portfolio strategies with respect to changes in their risk/return relationships for increasing TEs and (b) an enlarged section of Figure 4(a)
- Figure 6. Performance evaluation of the six portfolio strategies with respect to their (a) Sharpe ratios and (b) M2 ratios for incremental increases in TE
- Figure 7. (a) Performance of the six portfolio strategies with respect to their IRs and (b) correlation of benchmark and each strategy’s returns, as a function of TE
- Figure 8. The loci of possible (a) Sharpe ratios, (b) M2 ratios and (c) IRs – as a function of portfolio risk – for increasing TEs
- Figure 9. The loci of possible (a) Sharpe ratios, (b) M2 ratios and (c) IRs – as a function of portfolio return – for increasing TEs
- Figure 10. Explanation of performance ratio plateaus as TE →9%→15%→18%. The efficient frontier is the darker grey line to which the CML is tangent
-
- Table 1. Stylized input data
-
- Ammann, M., & Tobler, J. (2000). Measurement and decomposition of tracking error variance (Working Paper). University of St Gallen.
- Bajeux-Besnainou, I., Belhaj, R., Maillard, D., & Portait, R. (2011). Portfolio optimization under tracking error and weights constraints. The Journal of Financial Research, 34(2), 295-330.
- Brenchley, D. (2018). Why it pays to back active fund management in 2018. Morningstar.
- Cairns, P. (2018). So, You Think Passive Investing Can’t Work in SA? And Yet It Does. Money Web Investing, 1.
- Chan, L., Karceski, J., & Lakonishok, J. (1999). On portfolio optimization: forecasting covariances and choosing the risk model. The Review of Financial Studies, 12(3), 937-974.
- Chen, W. (2016). Portfolio optimisation models and meanvariance spanning. Handbook of Quantitative Finance and Risk Management, 1.
- Choueifaty, Y. (2006). United States Patent No. USPTO 60/816,276.
- Daly, M., Maxwell, M., & van Vuuren, G. (2018). Feasible portfolios under tracking error, β, α and utility constraints. Investment Management and Financial Innovations, 15(1), 141-153.
- Gilreath, D. (2017). The tide has turned: Active outpacing passive investing. CNBC, 1.
- Goodwin, T. H. (1998). The information ratio. Financial Analysts Journal, 54(4), 34-43.
- Jorion, P. (2003). Portfolio optimisation with tracking error constraints. Financial Analysts Journal, 59(5), 70-82.
- Lambridis, J. (2017). Why active management beats passive in South Africa (Prudential Article Releases).
- Lintner, J. (1965). The valuation of risky assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics and Statistics, 47(1), 13-37.
- Livingston, L. S. (2013). Intraportfolio correlation: An application for investments students. Business Education and Accreditation, 5(1), 91-105.
- Maillard, S., Roncalli, T., & Teiletche, J. (2010). The properties of equally-weighted risk contributions portfolios. The Journal of Portfolio Management, 36(4), 60-70.
- Markowitz, H. M. (1952). Portfolio Selection. The Journal of Finance, 7(1), 77-91.
- Maxwell, M., Daly, M., Thomson, D., & van Vuuren, G. (2018). Optimising tracking errorconstrained portfolios. Applied Economics, 50(54), 5846-5858.
- Merton, R. C. (1972). An analytic derivation of the efficient portfolio frontier. Journal of Financial and Quantitative Analysis, 7(4), 1851-1872.
- Modigliani, L., & Modigliani, F. (1997). Risk-adjusted performance. Journal of Portfolio Management, 23(2), 45-54.
- Mossin, J. (1966). Equilibrium in a capital asset market. Econometrica, 34(4), 768-783.
- Pemberton, M., & Rau, N. (2007). Mathematics for economists: an introductory textbook. Manchester: Manchester University Press.
- Reilly, F., & Brown, K. (2009). Investment analysis and portfolio management (10th ed.). Mason, OH: South-Western Cengage Learning.
- Roll, R. (1992). A mean/variance analysis of tracking error. The Journal of Portfolio Management, 18(4), 13-22.
- Sharpe, W. F. (1964). Capital Asset Prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19(3), 425-442.
- Sharpe, W. F. (1966). Mutual fund performance. The Journal of Portfolio Management, 39(1), 199-138.
- Sharpe, W. F. (1991). The arithmetic of active management. Financial Analysts Journal, 47(1), 7-9.
- Theron, L., & van Vuuren, G. (2018). The maximum diversification investment strategy: a portfolio performance comparison. Cogent Economics and Finance, 6(1), 1-16.
- Thomas, B., Rottschafer, D., & Zvingelis, J. (2013). A tracking error primer. Envestnet PMC, 1-5.
- Torr, A. (2018). Fortunes of active management industry look set to improve. Business Day.
- Treynor, J. L. (1961). Market value, time and risk (Unpublished Manuscript, dated 8/8/61, #95-209).
- Treynor, J. L. (1965). How to rate management of investment funds. Harvard Business Review, 43(1), 63-75.
- Varadi, D., Kapler, M., Bee, H., & Rittenhouse, C. (2012). The minimum correlation algorithm: a practical diversification tool. Flexible plan investments.