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A Relative View on Tracking Error

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Author Info
Hallerbach, W.G.P.M.
Pouchkarev, I. (Erasmus Research Institute of Management (ERIM), RSM Erasmus University)

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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.

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Publisher Info
Paper provided by 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. in its series Research Paper with number ERS-2005-063-F&A Revision_Date: 2009-07-29.

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Date of creation: 04 Nov 2005
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Handle: RePEc:dgr:eureri:30007691

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Related research
Keywords: Benchmarking; Tracking Error; Information Ratio; Performance Evaluation;

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  1. 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. [Downloadable!] (restricted)
  2. Fisher, Lawrence & Lorie, James H, 1970. "Some Studies of Variability of Returns on Investments in Common Stocks," Journal of Business, University of Chicago Press, vol. 43(2), pages 99-134, April. [Downloadable!] (restricted)
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This page was last updated on 2009-12-2.

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