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Active portfolio management with benchmarking: A frontier based on alpha

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

Active portfolio management often involves the objective of selecting a portfolio with minimum tracking error variance (TEV) for some expected gain in return over a benchmark. However, Roll (1992) shows that such portfolios are generally suboptimal because they do not belong to the mean-variance frontier and are thus overly risky. Our paper proposes an appealing method to lessen this suboptimality that involves the objective of selecting a portfolio from the set of portfolios that have minimum TEV for various levels of ex-ante alpha, which we refer to as the alpha-TEV frontier. Since practitioners commonly use ex-post alpha to assess the performance of managers, the use of this frontier aligns the objectives of managers with how their performance is evaluated. Furthermore, sensible choices of ex-ante alpha lead to the selection of portfolios that are less risky (in variance terms) than the portfolios that active managers would otherwise select.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 34 (2010)
Issue (Month): 9 (September)
Pages: 2185-2197

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Handle: RePEc:eee:jbfina:v:34:y:2010:i:9:p:2185-2197
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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