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Optimizing tracking error-constrained portfolios

Author

Listed:
  • Michael Maxwell
  • Michael Daly
  • Daniel Thomson
  • Gary van Vuuren

Abstract

Active portfolios subject to tracking error (TE) constraints are the typical setup for active managers tasked with outperforming a benchmark. The risk and return relationship of such constrained portfolios is described by an ellipse in traditional mean-variance space and the ellipse’s flat shape suggests an additional constraint which improves the performance of the active portfolio. Although subsequent work isolated and explored different portfolios subject to these constraints, absolute portfolio risk has been consistently ignored. A different restriction – maximization of the traditional Sharpe ratio on the constant TE frontier in absolute risk/return space – is added here to the existing constraint set, and a method to generate this portfolio is explained. The resultant portfolio has a lower volatility and higher return than the benchmark, it satisfies the TE constraint and the ratio of excess absolute return to risk is maximized (i.e. maximum Sharpe ratio in absolute space).

Suggested Citation

  • Michael Maxwell & Michael Daly & Daniel Thomson & Gary van Vuuren, 2018. "Optimizing tracking error-constrained portfolios," Applied Economics, Taylor & Francis Journals, vol. 50(54), pages 5846-5858, November.
  • Handle: RePEc:taf:applec:v:50:y:2018:i:54:p:5846-5858
    DOI: 10.1080/00036846.2018.1488069
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    References listed on IDEAS

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    1. Philippe Bertrand, 2009. "Risk-adjusted performance attribution and portfolio optimisations under tracking-error constraints," Post-Print hal-01833079, HAL.
    2. Philippe Bertrand, 2005. "A Note on Portfolio Performance Attribution: Taking Risk into Account," Post-Print hal-01833107, HAL.
    3. Philippe Bertrand & Jean-Luc Prigent & Raphael Sobotka, 2000. "Optimisation de portefeuille sous contrainte de variance de la tracking-error," Post-Print hal-01833150, HAL.
    4. Nadima El-Hassan & Paul Kofman, 2003. "Tracking Error and Active Portfolio Management," Australian Journal of Management, Australian School of Business, vol. 28(2), pages 183-207, September.
    5. Philippe Bertrand, 2010. "Another Look at Portfolio Optimization under Tracking-Error Constraints," Post-Print hal-01833085, HAL.
    6. Philippe Bertrand, 2010. "Another Look at Portfolio Optimization under Tracking-Error Constraints," Post-Print hal-01833061, HAL.
    7. 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.
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    Cited by:

    1. Wade Gunning & Gary van Vuuren, 2019. "Exploring the drivers of tracking error constrained portfolio performance," Cogent Economics & Finance, Taylor & Francis Journals, vol. 7(1), pages 1684181-168, January.
    2. Michael Maxwell & Gary Vuuren, 2019. "Active Investment Strategies under Tracking Error Constraints," International Advances in Economic Research, Springer;International Atlantic Economic Society, vol. 25(3), pages 309-322, August.

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