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Tracking Error and Tactical Asset Allocation

Posted: 29 Jun 2001  

Manuel Ammann

University of St. Gallen - School of Finance

Heinz Zimmermann

University of Basel - Center for Economic Science (WWZ) - Department of Finance

Abstract

We report our investigation of the relationship between statistical measures of tracking error and asset allocation restrictions expressed as admissible weight ranges. Tracking errors are typically calculated as annualized second moments of return differentials between a portfolio and a benchmark. In practice, however, constraints on tactical deviations from benchmark weights are often imposed on the portfolio manager to ensure adequate tracking. Simulating various investment strategies subject to such constraints, we illustrate how the size of acceptable deviations from the benchmark relates to the statistical tracking error. An example based on actual market data indicates that imposing fairly large tactical asset allocation ranges produces surprisingly small tracking errors. We also found that TAA restrictions should not only restrict the tactical ranges of the individual asset classes but also, and perhaps even more importantly, the tracking of the individual asset classes.

Suggested Citation

Ammann, Manuel and Zimmermann, Heinz, Tracking Error and Tactical Asset Allocation. Financial Analysts Journal, Vol. 57, No. 2, March/April 2001. Available at SSRN: https://ssrn.com/abstract=266676

Manuel Ammann (Contact Author)

University of St. Gallen - School of Finance ( email )

Unterer Graben 21
St.Gallen, CH-9000
Switzerland

Heinz Zimmermann

University of Basel - Center for Economic Science (WWZ) - Department of Finance ( email )

Peter Merian Weg 6
Basel, 4002
Switzerland
+41 61 267 33 16 (Phone)
+41 61 267 08 98 (Fax)

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