Tracking Error Allocation
Journal of Portfolio Management, Vol. 27, No. 4, pp. 19-25, 2001
Posted: 20 Jul 2010
Date Written: January 1, 2001
This article presents a 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.
Keywords: Risk budgeting, tracking error, risk management
JEL Classification: G11
Suggested Citation: Suggested Citation