Noël Amenc, Philippe Malaise, Lionel Martellini: Tracking error is not necessarily bad. Just like with good and bad cholesterol, there is “good” tracking error, which refers to outperformance of a portfolio with respect to the benchmark, and “bad” tracking error, which refers to underperformance with respect to the benchmark.
Professor of Finance, EDHEC Business SchoolDirector, EDHEC-Risk Institute
Professor of Finance, EDHEC Business SchoolAssociate Researcher, EDHEC-Risk Institute
Professor of Finance, EDHEC Business SchoolScientific Director, EDHEC-Risk Institute
By severely restricting the amounts invested in active strategies as a result of tight tracking error constraints, investors forgive an opportunity for significant outperformance, especially during market downturns. In this paper, we introduce a new methodology that allows investors to gain full access to good tracking error, while maintaining the level of bad tracking error below a given threshold, based on an optimal dynamic adjustment of the fractions invested in a passive core versus an active satellite portfolio. This method can be regarded as a natural extension of constant proportion portfolio insurance techniques, originally designed to ensure the respect of absolute performance, to a relative return context.
|Research Cluster :||Finance|