Tracking Error Allocation

Journal of Portfolio Management, Vol. 27, No. 4, pp. 19-25, 2001

Posted: 20 Jul 2010

See all articles by David Blitz

David Blitz

Robeco Quantitative Investments

Jouke Hottinga

AEGON Group

Date Written: January 1, 2001

Abstract

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

Blitz, David and Hottinga, Jouke, Tracking Error Allocation (January 1, 2001). Journal of Portfolio Management, Vol. 27, No. 4, pp. 19-25, 2001. Available at SSRN: https://ssrn.com/abstract=1645162

David Blitz (Contact Author)

Robeco Quantitative Investments ( email )

Weena 850
Rotterdam, 3014 DA
Netherlands

Jouke Hottinga

AEGON Group ( email )

2501 CE The Hague
Netherlands

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