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Allocating the tracking error for the multi-asset-class fund by reconciling bottom-up model with top-down model

Author

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  • Korkiat Sermsakskul

    (Department of Banking and Finance, Faculty of Commerce and Accountancy, Chulalongkorn University, Phyathai Road, Pathumwan, Bangkok 10330, Thailand)

  • Sira Suchintabandid

    (Department of Banking and Finance, Faculty of Commerce and Accountancy, Chulalongkorn University, Phyathai Road, Pathumwan, Bangkok 10330, Thailand)

Abstract

In a portfolio with multiple asset classes, each having its own benchmark, an alpha-seeking manager must decide how much tracking error (TE) to incur in each asset class, subject to given TE constraints. This paper helps practitioners clarify how to formulate this TE-allocation problem from a top-down perspective. By reconciling with a conceptual bottom-up formulation, we discover that the validity of the top-down model relies crucially on how one specifies the correlation structure of the asset classes’ alphas. We propose a method for estimating this correlation structure that helps users of the top-down model avoid misallocation of TEs.

Suggested Citation

  • Korkiat Sermsakskul & Sira Suchintabandid, 2023. "Allocating the tracking error for the multi-asset-class fund by reconciling bottom-up model with top-down model," International Journal of Financial Engineering (IJFE), World Scientific Publishing Co. Pte. Ltd., vol. 10(01), pages 1-29, March.
    • Handle: RePEc:wsi:ijfexx:v:10:y:2023:i:01:n:s2424786323500068
    DOI: 10.1142/S2424786323500068
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