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Comparing the performance and composition of tracking error constrained and unconstrained portfolios

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  • du Sart, Colin F.
  • van Vuuren, Gary W.

Abstract

Active portfolios subject to tracking error constraints are bound by an ellipse in absolute risk-return space, known as the constant tracking error frontier, where the absolute risk is the standard deviation of portfolio returns. Portfolios within this space are presented: Jorion’s (2003) portfolio, which lies on the frontier and has the same risk as the benchmark, and the maximum Sharpe ratio portfolio (also on the frontier and referred to as the constant tracking error constrained market portfolio in this paper). Using historical data from an emerging market (South Africa), the performance and composition of these portfolios are explored and compared with the traditional market portfolio (the maximum Sharpe portfolio on the efficient frontier). The results illustrate how these portfolios perform during bull and bear markets and provide an indication of the positions in assets and the amount of rebalancing required to maintain these portfolios: (i) Contrary to theory, the returns and Sharpe ratio of the traditional market portfolio are substantially worse than the constrained portfolios for extended periods of time; (ii) The constrained portfolios perform similarly and require less rebalancing; (iii) There is evidence for statistically significant correlations between the compositions of the traditional market portfolio and the constrained portfolios, and further research is recommended. This work may be used to install optimal risk-adjusted active investment strategies net of transaction costs.

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  • du Sart, Colin F. & van Vuuren, Gary W., 2021. "Comparing the performance and composition of tracking error constrained and unconstrained portfolios," The Quarterly Review of Economics and Finance, Elsevier, vol. 81(C), pages 276-287.
    • Handle: RePEc:eee:quaeco:v:81:y:2021:i:c:p:276-287
    DOI: 10.1016/j.qref.2021.06.019
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    References listed on IDEAS

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    Cited by:

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    More about this item

    Keywords

    Active portfolio optimisation; Efficient frontier; Tracking error frontier;
    All these keywords.

    JEL classification:

    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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