IDEAS home Printed from https://ideas.repec.org/a/taf/applec/v50y2018i54p5846-5858.html
   My bibliography  Save this article

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
    as

    Download full text from publisher

    File URL: http://hdl.handle.net/10.1080/00036846.2018.1488069
    Download Restriction: Access to full text is restricted to subscribers.
    File URL: https://libkey.io/10.1080/00036846.2018.1488069?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    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. Philippe Bertrand, 2005. "A note on portfolio performance attribution: Taking risk into account," Journal of Asset Management, Palgrave Macmillan, vol. 5(6), pages 428-437, April.
    2. Philippe Bertrand, 2010. "Another Look at Portfolio Optimization under Tracking-Error Constraints," Post-Print hal-01833085, HAL.
    3. Philippe Bertrand, 2010. "Another Look at Portfolio Optimization under Tracking-Error Constraints," Post-Print hal-01833061, HAL.
    4. 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.
    5. Philippe Bertrand, 2009. "Risk-adjusted performance attribution and portfolio optimisations under tracking-error constraints," Journal of Asset Management, Palgrave Macmillan, vol. 10(2), pages 75-88, June.
    6. Philippe Bertrand, 2005. "A note on portfolio performance attribution: Taking risk into account," Post-Print hal-01833048, HAL.
    7. Philippe Bertrand & Jean-Luc Prigent & Raphael Sobotka, 2000. "Optimisation de portefeuille sous contrainte de variance de la tracking-error," Post-Print hal-01833150, HAL.
    8. 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.
    9. Luca RICCETTI, 2010. "Minimum Tracking Error Volatility," Working Papers 340, Universita' Politecnica delle Marche (I), Dipartimento di Scienze Economiche e Sociali.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. du Sart, Colin F. & van Vuuren, Gary W., 2021. "Comparing the performance and composition of tracking error constrained and unconstrained portfolios," The Quarterly Review of Economics and Finance, Elsevier, vol. 81(C), pages 276-287.
    2. L. Theron & G. van Vuuren, 2020. "Exploring the Behaviour of Actively Managed, Maximally Diversified Portfolios," Studies in Economics and Econometrics, Taylor & Francis Journals, vol. 44(2), pages 49-72, August.
    3. Tingting Yang & Xiaoxia Huang, 2022. "A New Portfolio Optimization Model Under Tracking-Error Constraint with Linear Uncertainty Distributions," Journal of Optimization Theory and Applications, Springer, vol. 195(2), pages 723-747, November.
    4. Riccardo Lucchetti & Mihaela Nicolau & Giulio Palomba & Luca Riccetti, 2022. "Reconciling TEV and VaR in Active Portfolio Management: A New Frontier," Working Papers 461, Universita' Politecnica delle Marche (I), Dipartimento di Scienze Economiche e Sociali.
    5. 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.
    6. 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.

    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. 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. L. Theron & G. van Vuuren, 2020. "Exploring the Behaviour of Actively Managed, Maximally Diversified Portfolios," Studies in Economics and Econometrics, Taylor & Francis Journals, vol. 44(2), pages 49-72, August.
    3. Riccardo Lucchetti & Mihaela Nicolau & Giulio Palomba & Luca Riccetti, 2022. "Reconciling TEV and VaR in Active Portfolio Management: A New Frontier," Working Papers 461, Universita' Politecnica delle Marche (I), Dipartimento di Scienze Economiche e Sociali.
    4. du Sart, Colin F. & van Vuuren, Gary W., 2021. "Comparing the performance and composition of tracking error constrained and unconstrained portfolios," The Quarterly Review of Economics and Finance, Elsevier, vol. 81(C), pages 276-287.
    5. Philippe Bertrand, 2009. "Risk-adjusted performance attribution and portfolio optimisations under tracking-error constraints," Journal of Asset Management, Palgrave Macmillan, vol. 10(2), pages 75-88, June.
    6. Paskalis Glabadanidis & Leon Zolotoy, 2013. "Benchmark replication portfolio strategies," Journal of Asset Management, Palgrave Macmillan, vol. 14(2), pages 95-110, April.
    7. Palomba, Giulio & Riccetti, Luca, 2012. "Portfolio frontiers with restrictions to tracking error volatility and value at risk," Journal of Banking & Finance, Elsevier, vol. 36(9), pages 2604-2615.
    8. 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.
    9. 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.
    10. Rand Kwong Yew Low, 2018. "Vine copulas: modelling systemic risk and enhancing higher‐moment portfolio optimisation," Accounting and Finance, Accounting and Finance Association of Australia and New Zealand, vol. 58(S1), pages 423-463, November.
    11. Muhinyuza, Stanislas & Bodnar, Taras & Lindholm, Mathias, 2020. "A test on the location of the tangency portfolio on the set of feasible portfolios," Applied Mathematics and Computation, Elsevier, vol. 386(C).
    12. Shuzhen Yang, 2019. "A varying terminal time mean-variance model," Papers 1909.13102, arXiv.org, revised Jan 2020.
    13. Zied Ftiti & Aviral Tiwari & Amél Belanès & Khaled Guesmi, 2015. "Tests of Financial Market Contagion: Evolutionary Cospectral Analysis Versus Wavelet Analysis," Computational Economics, Springer;Society for Computational Economics, vol. 46(4), pages 575-611, December.
    14. Chiu-Ming Hsiao, 2022. "Economic Growth, CO 2 Emissions Quota and Optimal Allocation under Uncertainty," Sustainability, MDPI, vol. 14(14), pages 1-26, July.
    15. Paskalis Glabadanidis, 2020. "Portfolio Strategies to Track and Outperform a Benchmark," JRFM, MDPI, vol. 13(8), pages 1-26, August.
    16. Alexander, Gordon J. & Baptista, Alexandre M., 2006. "Portfolio selection with a drawdown constraint," Journal of Banking & Finance, Elsevier, vol. 30(11), pages 3171-3189, November.
    17. Min Dai & Zuo Quan Xu & Xun Yu Zhou, 2009. "Continuous-Time Markowitz's Model with Transaction Costs," Papers 0906.0678, arXiv.org.
    18. Wang, Zengwu & Xia, Jianming & Zhang, Lihong, 2007. "Optimal investment for an insurer: The martingale approach," Insurance: Mathematics and Economics, Elsevier, vol. 40(2), pages 322-334, March.
    19. Matus Medo & Chi Ho Yeung & Yi-Cheng Zhang, 2008. "How to quantify the influence of correlations on investment diversification," Papers 0805.3397, arXiv.org, revised Feb 2009.
    20. Fu, Chenpeng & Lari-Lavassani, Ali & Li, Xun, 2010. "Dynamic mean-variance portfolio selection with borrowing constraint," European Journal of Operational Research, Elsevier, vol. 200(1), pages 312-319, January.

    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:taf:applec:v:50:y:2018:i:54:p:5846-5858. 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: Chris Longhurst (email available below). General contact details of provider: http://www.tandfonline.com/RAEC20 .

    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.