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Active Investment Strategies under Tracking Error Constraints

Author

Listed:
  • Michael Maxwell

    (North West University)

  • Gary Vuuren

    (North West University)

Abstract

Active portfolio managers are judged on their ability to outperform agent’s benchmarks, so optimising fund returns is important. Maximising fund outperformance is, however, non-trivial because active portfolios are subject to tracking error (TE) and other constraints. Feasible portfolios constrained by TE are bounded by an elliptical frontier in mean/variance space and may not be efficient. Also, ‘optimal’ can involve different objectives for different investors. Previous attempts to isolate optimal portfolios on the constant TE frontier have been limited to the maximum return, minimum risk and benchmark risk portfolios. More recently, the maximum risk-adjusted return portfolio on this frontier was identified. Using a highly stylised portfolio comprising only three assets for clarity and ease of explanation, we review for the first time existing optimal portfolio assemblies and introduce other possibilities: TE-constrained portfolios which are maximally diversified, exhibit risk parity, and have minimal intra-correlation between constituents. The methodology to generate optimal risk weights for these portfolios is explained and the way risk/return profiles change as TE changes is characterised. The way portfolios move in risk/return space in a changing TE milieu could initiate novel investment strategies for active fund managers.

Suggested Citation

  • Michael Maxwell & Gary Vuuren, 2019. "Active Investment Strategies under Tracking Error Constraints," International Advances in Economic Research, Springer;International Atlantic Economic Society, vol. 25(3), pages 309-322, August.
  • Handle: RePEc:kap:iaecre:v:25:y:2019:i:3:d:10.1007_s11294-019-09746-3
    DOI: 10.1007/s11294-019-09746-3
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    References listed on IDEAS

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    1. repec:dau:papers:123456789/4688 is not listed on IDEAS
    2. Cheng, Pao Lun, 1971. "Efficient Portfolio Selections beyond the Markowitz Frontier," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 6(5), pages 1207-1234, December.
    3. Bodnar, Taras & Parolya, Nestor & Schmid, Wolfgang, 2018. "Estimation of the global minimum variance portfolio in high dimensions," European Journal of Operational Research, Elsevier, vol. 266(1), pages 371-390.
    4. Philippe Bertrand, 2005. "A note on portfolio performance attribution: Taking risk into account," Post-Print hal-01833048, HAL.
    5. Philippe Bertrand, 2005. "A note on portfolio performance attribution: Taking risk into account," Journal of Asset Management, Palgrave Macmillan, vol. 5(6), pages 428-437, April.
    6. Lynda S. Livingston, 2013. "Intraportfolio Correlation: An Application For Investments Students," Business Education and Accreditation, The Institute for Business and Finance Research, vol. 5(1), pages 91-105.
    7. Michael Maxwell & Michael Daly & Daniel Thomson & Gary van Vuuren, 2018. "Optimizing tracking error-constrained portfolios," Applied Economics, Taylor & Francis Journals, vol. 50(54), pages 5846-5858, November.
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    Citations

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    Cited by:

    1. Wade Gunning & Gary van Vuuren, 2019. "Exploring the drivers of tracking error constrained portfolio performance," Cogent Economics & Finance, Taylor & Francis Journals, vol. 7(1), pages 1684181-168, January.
    2. Ibrahim Filiz & Jan René Judek & Marco Lorenz & Markus Spiwoks, 2021. "Sticky Stock Market Analysts," JRFM, MDPI, vol. 14(12), pages 1-27, December.

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    More about this item

    Keywords

    Tracking error frontier; Optimal portfolios; Investment constraints;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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