Active portfolio management with benchmarking: A frontier based on alpha

Gordon J. Alexander, Alexandre M. Baptista

Research output: Contribution to journalArticlepeer-review

23 Scopus citations

Abstract

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.

Original languageEnglish (US)
Pages (from-to)2185-2197
Number of pages13
JournalJournal of Banking and Finance
Volume34
Issue number9
DOIs
StatePublished - Sep 2010

Bibliographical note

Funding 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.

Copyright:
Copyright 2010 Elsevier B.V., All rights reserved.

Keywords

  • Active portfolio management
  • Alpha
  • Benchmarking
  • Risk management
  • Tracking error

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