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A Relative View on Tracking Error

Author

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  • Hallerbach, W.G.P.M.
  • Pouchkarev, I.

Abstract

When delegating an investment decisions to a professional manager, investors often anchor their mandate to a specific benchmark. The manager’s exposure to risk is controlled by means of a tracking error volatility constraint. It depends on market conditions whether this constraint is easily met or violated. Moreover, the performance of the portfolio depends on market conditions. In this paper we argue that these mandated portfolios should not only be evaluated relative to their benchmarks in order to appraise their performance. They should also be evaluated relative to the opportunity set of all portfolios that can be formed under the same mandate – the portfolio opportunity set. The distribution of performance values over the portfolio opportunity set depends on contemporary market dynamics. To correct for this, we suggest a normalized version of the information ratio that is invariant to these market conditions.

Suggested Citation

  • Hallerbach, W.G.P.M. & Pouchkarev, I., 2005. "A Relative View on Tracking Error," ERIM Report Series Research in Management ERS-2005-063-F&A, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus University Rotterdam.
    • Handle: RePEc:ems:eureri:7020
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    References listed on IDEAS

    as
    1. Robert L. Smith, 1984. "Efficient Monte Carlo Procedures for Generating Points Uniformly Distributed over Bounded Regions," Operations Research, INFORMS, vol. 32(6), pages 1296-1308, December.
    2. Fisher, Lawrence & Lorie, James H, 1970. "Some Studies of Variability of Returns on Investments in Common Stocks," The Journal of Business, University of Chicago Press, vol. 43(2), pages 99-134, April.
    3. Alexander, Gordon J. & Baptista, Alexandre M., 2008. "Active portfolio management with benchmarking: Adding a value-at-risk constraint," Journal of Economic Dynamics and Control, Elsevier, vol. 32(3), pages 779-820, March.
    4. Ritov, Y., 1989. "Monte Carlo computation of the mean of a function with convex support," Computational Statistics & Data Analysis, Elsevier, vol. 7(3), pages 269-277, February.
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    More about this item

    Keywords

    Benchmarking; Information Ratio; Performance Evaluation; Tracking Error;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G3 - Financial Economics - - Corporate Finance and Governance
    • M - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics

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