IDEAS home Printed from https://ideas.repec.org/a/eee/dyncon/v32y2008i3p779-820.html
   My bibliography  Save this article

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

Author

Listed:
  • Alexander, Gordon J.
  • Baptista, Alexandre M.

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.

Suggested Citation

  • 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.
    • Handle: RePEc:eee:dyncon:v:32:y:2008:i:3:p:779-820
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0165-1889(07)00092-9
    Download Restriction: Full text for ScienceDirect subscribers only
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Gordon J. Alexander & Alexandre M. Baptista, 2004. "A Comparison of VaR and CVaR Constraints on Portfolio Selection with the Mean-Variance Model," Management Science, INFORMS, vol. 50(9), pages 1261-1273, September.
    2. Brennan, Michael J., 1993. "Agency and Asset Pricing," University of California at Los Angeles, Anderson Graduate School of Management qt53k014sd, Anderson Graduate School of Management, UCLA.
    3. Jennifer N. Carpenter, 2000. "Does Option Compensation Increase Managerial Risk Appetite?," Journal of Finance, American Finance Association, vol. 55(5), pages 2311-2331, October.
    4. Juan-Pedro Gomez & Fernando Zapatero, 2003. "Asset pricing implications of benchmarking: a two-factor CAPM," The European Journal of Finance, Taylor & Francis Journals, vol. 9(4), pages 343-357.
    5. Berk, Jonathan B., 1997. "Necessary Conditions for the CAPM," Journal of Economic Theory, Elsevier, vol. 73(1), pages 245-257, March.
    6. Admati, Anat R & Pfleiderer, Paul, 1997. "Does It All Add Up? Benchmarks and the Compensation of Active Portfolio Managers," The Journal of Business, University of Chicago Press, vol. 70(3), pages 323-350, July.
    7. Alexander, Gordon J. & Baptista, Alexandre M., 2002. "Economic implications of using a mean-VaR model for portfolio selection: A comparison with mean-variance analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 26(7-8), pages 1159-1193, July.
    8. Bertsimas, Dimitris & Lauprete, Geoffrey J. & Samarov, Alexander, 2004. "Shortfall as a risk measure: properties, optimization and applications," Journal of Economic Dynamics and Control, Elsevier, vol. 28(7), pages 1353-1381, April.
    9. Edwin J. Elton & Martin J. Gruber & Christopher R. Blake, 2003. "Incentive Fees and Mutual Funds," Journal of Finance, American Finance Association, vol. 58(2), pages 779-804, April.
    10. Chevalier, Judith & Ellison, Glenn, 1997. "Risk Taking by Mutual Funds as a Response to Incentives," Journal of Political Economy, University of Chicago Press, vol. 105(6), pages 1167-1200, December.
    11. Jennifer Carpenter, 1999. "Does Option Compensation Increase Managerial Risk Appetite?," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-076, New York University, Leonard N. Stern School of Business-.
    12. Erik R. Sirri & Peter Tufano, 1998. "Costly Search and Mutual Fund Flows," Journal of Finance, American Finance Association, vol. 53(5), pages 1589-1622, October.
    13. Mark Grinblatt & Sheridan Titman, 1989. "Adverse Risk Incentives and the Design of Performance-Based Contracts," Management Science, INFORMS, vol. 35(7), pages 807-822, July.
    14. Almazan, Andres & Brown, Keith C. & Carlson, Murray & Chapman, David A., 2004. "Why constrain your mutual fund manager?," Journal of Financial Economics, Elsevier, vol. 73(2), pages 289-321, August.
    15. Best, Michael J & Grauer, Robert R, 1991. "On the Sensitivity of Mean-Variance-Efficient Portfolios to Changes in Asset Means: Some Analytical and Computational Results," The Review of Financial Studies, Society for Financial Studies, vol. 4(2), pages 315-342.
    16. Alexander, Gordon J. & Baptista, Alexandre M., 2006. "Does the Basle Capital Accord reduce bank fragility? An assessment of the value-at-risk approach," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1631-1660, October.
    17. Philippe Artzner & Freddy Delbaen & Jean‐Marc Eber & David Heath, 1999. "Coherent Measures of Risk," Mathematical Finance, Wiley Blackwell, vol. 9(3), pages 203-228, July.
    18. Tokat, Yesim & Rachev, Svetlozar T. & Schwartz, Eduardo S., 2003. "The stable non-Gaussian asset allocation: a comparison with the classical Gaussian approach," Journal of Economic Dynamics and Control, Elsevier, vol. 27(6), pages 937-969, April.
    19. Starks, Laura T., 1987. "Performance Incentive Fees: An Agency Theoretic Approach," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(1), pages 17-32, March.
    20. Merton, Robert C., 1972. "An Analytic Derivation of the Efficient Portfolio Frontier," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 7(4), pages 1851-1872, September.
    21. Owen, Joel & Rabinovitch, Ramon, 1983. "On the Class of Elliptical Distributions and Their Applications to the Theory of Portfolio Choice," Journal of Finance, American Finance Association, vol. 38(3), pages 745-752, June.
    22. Alexander, Gordon J, 1993. "Short Selling and Efficient Sets," Journal of Finance, American Finance Association, vol. 48(4), pages 1497-1506, September.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Alexander, Gordon J. & Baptista, Alexandre M., 2010. "Active portfolio management with benchmarking: A frontier based on alpha," Journal of Banking & Finance, Elsevier, vol. 34(9), pages 2185-2197, September.
    2. Livio Stracca, 2006. "Delegated Portfolio Management: A Survey Of The Theoretical Literature," Journal of Economic Surveys, Wiley Blackwell, vol. 20(5), pages 823-848, December.
    3. Agarwal, Vikas & Gómez, Juan-Pedro & Priestley, Richard, 2012. "Management compensation and market timing under portfolio constraints," Journal of Economic Dynamics and Control, Elsevier, vol. 36(10), pages 1600-1625.
    4. Basak, Suleyman & Pavlova, Anna & Shapiro, Alex, 2003. "Offsetting the Incentives: Risk Shifting and Benefits of Benchmarking in Money Management," Working papers 4303-03, Massachusetts Institute of Technology (MIT), Sloan School of Management.
    5. Baptista, Alexandre M., 2008. "Optimal delegated portfolio management with background risk," Journal of Banking & Finance, Elsevier, vol. 32(6), pages 977-985, June.
    6. Ferson, Wayne E., 2013. "Investment Performance: A Review and Synthesis," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 969-1010, Elsevier.
    7. Suleyman Basak & Anna Pavlova & Alexander Shapiro, 2007. "Optimal Asset Allocation and Risk Shifting in Money Management," The Review of Financial Studies, Society for Financial Studies, vol. 20(5), pages 1583-1621, 2007 21.
    8. Jennifer Huang & Clemens Sialm & Hanjiang Zhang, 2011. "Risk Shifting and Mutual Fund Performance," The Review of Financial Studies, Society for Financial Studies, vol. 24(8), pages 2575-2616.
    9. Cuoco, Domenico & Kaniel, Ron, 2011. "Equilibrium prices in the presence of delegated portfolio management," Journal of Financial Economics, Elsevier, vol. 101(2), pages 264-296, August.
    10. Servaes, Henri & Sigurdsson, Kari, 2022. "The Costs and Benefits of Performance Fees in Mutual Funds," Journal of Financial Intermediation, Elsevier, vol. 50(C).
    11. Taras Bodnar & Mathias Lindholm & Erik Thorsén & Joanna Tyrcha, 2021. "Quantile-based optimal portfolio selection," Computational Management Science, Springer, vol. 18(3), pages 299-324, July.
    12. Ping Hu & Jayant Kale & Ajay Subramanian, 2003. "Compensation, Career Concerns, and Relative Risk Choices by Mutual Fund Managers: Theory and Evidence," Levine's Bibliography 666156000000000349, UCLA Department of Economics.
    13. Kempf, Alexander & Ruenzi, Stefan & Thiele, Tanja, 2009. "Employment risk, compensation incentives, and managerial risk taking: Evidence from the mutual fund industry," Journal of Financial Economics, Elsevier, vol. 92(1), pages 92-108, April.
    14. Sotes-Paladino, Juan & Zapatero, Fernando, 2022. "Carrot and stick: A role for benchmark-adjusted compensation in active fund management," Journal of Financial Intermediation, Elsevier, vol. 52(C).
    15. Sheng, Jiliang & Wang, Jian & Wang, Xiaoting & Yang, Jun, 2014. "Asymmetric contracts, cash flows and risk taking of mutual funds," Economic Modelling, Elsevier, vol. 38(C), pages 435-442.
    16. Alexander, Gordon J. & Baptista, Alexandre M., 2011. "Portfolio selection with mental accounts and delegation," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2637-2656, October.
    17. Ching-mann Huang & Len-kuo Hu & Hsin-Hong Kang, 2005. "Compensation Design and Career Concerns of Fund Manager," Review of Quantitative Finance and Accounting, Springer, vol. 24(4), pages 379-397, June.
    18. Basak, Suleyman & Pavlova, Anna & Shapiro, Alexander, 2008. "Offsetting the implicit incentives: Benefits of benchmarking in money management," Journal of Banking & Finance, Elsevier, vol. 32(9), pages 1883-1893, September.
    19. Taras Bodnar & Taras Zabolotskyy, 2017. "How risky is the optimal portfolio which maximizes the Sharpe ratio?," AStA Advances in Statistical Analysis, Springer;German Statistical Society, vol. 101(1), pages 1-28, January.
    20. Raphaëlle Bellando & Sébastien Ringuedé, 2007. "Compétition entre fonds et prise de risque excessive : une application empirique au cas des OPCVM actions de droit français," Post-Print halshs-00226341, HAL.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:dyncon:v:32:y:2008:i:3:p:779-820. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/jedc .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.