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.
Copyright 2010 Elsevier B.V., All rights reserved.
- Active portfolio management
- Risk management
- Tracking error