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Active portfolio management with benchmarking: Adding a value-at-risk constraint

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Author Info
Alexander, Gordon J.
Baptista, Alexandre M.

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Abstract

We examine the impact of adding a value-at-risk (VaR) constraint to the problem of an active manager who seeks to outperform a benchmark while minimizing tracking error variance (TEV) by using the model of Roll [1992. A mean/variance analysis of tracking error. Journal of Portfolio Management 18, 13-22]. We obtain three main results. First, portfolios on the constrained mean-TEV boundary still exhibit three-fund separation, but the weights of the three funds when the constraint binds differ from those in Roll's model. Second, the constraint mitigates the problem that when an active manager seeks to outperform a benchmark using the mean-TEV model, he or she selects an inefficient portfolio. Finally, when short sales are disallowed, the extent to which the constraint reduces the optimal portfolio's efficiency loss can still be notable but is smaller than when short sales are allowed.

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Publisher Info
Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 32 (2008)
Issue (Month): 3 (March)
Pages: 779-820
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Handle: RePEc:eee:dyncon:v:32:y:2008:i:3:p:779-820

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  1. Hallerbach, W.G.P.M. & Pouchkarev, I., 2005. "A Relative View on Tracking Error," Research Paper ERS-2005-063-F&A Revision, 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 Uni. [Downloadable!]
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