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.
Bibliographical noteFunding Information:
Our paper has benefited from the valuable comments of an anonymous referee. This version of the paper was largely written while Alexander was a Visiting Professor of Finance at the Massachusetts Institute of Technology. Baptista gratefully acknowledges research support from the School of Business at The George Washington University.
- Active portfolio management
- Risk management
- Tracking error