Components of Portfolio Variance
18 Pages Posted: 9 Jul 2014 Last revised: 5 Apr 2015
Date Written: April 5, 2015
An investment portfolio’s return variance is the sum of variance generated by passive systematic risk factor exposure, active security selection and active systematic risk factor timing. We show that the components of active risk can be estimated without knowledge of portfolio holdings. In a broad sample of US equity mutual funds classified as actively managed by Lipper in years 2000-2013, Carhart (1997) risk factors on average account for 94 %, security selection for 5 % and risk factor timing for 1 % of total variance. Security selection is positively associated to future performance, while systematic risk factor timing correlates negatively with future performance. Our new active variance measures – SelectionShare and TimingShare – complement ActiveShare and TrackingError in predicting future performance.
Keywords: selection, timing, performance, Tracking Error, ActiveShare
JEL Classification: G10, G11, G20, G23
Suggested Citation: Suggested Citation