Tracking error allocation
How can active managers ensure they maximize the added value from each investment decision? We propose a framework based on the tracking error (TE) concept for measuring relative risk.
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- Investment decisions should be considered independently
- Managers should allocate a partial TE to each decision
- Target TE should be proportional to the expected information ratio
This article1 presents a transparent framework for allocating partial tracking errors to investment decisions in order to maximize the expected information ratio of an actively managed portfolio. The tracking error allocation framework is a three–step process: 1) identifying the independent investment decisions; 2) ranking the forecasting capabilities for the investment decisions; and 3) calculating the optimum partial tracking errors, given an overall tracking error limit.
The key result is an understandable and transparent rule that says the target tracking error for each investment decision should be proportional to the corresponding expected information ratio. The authors illustrate the framework using examples that show some interesting practical consequences of an optimum tracking error allocation.
1 Blitz, D. C. and Hottinga, J., 2001, ‘Tracking error allocation’, The Journal of Portfolio Management.
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