A Relative View on Tracking Error

Abstract

When delegating an investment decisions to a professional manager, investors often anchor their mandate to a specific benchmark. The manager’s exposure to risk is controlled by means of a tracking error volatility constraint. It depends on market conditions whether this constraint is easily met or violated. Moreover, the performance of the portfolio depends on market conditions. In this paper we argue that these mandated portfolios should not only be evaluated relative to their benchmarks in order to appraise their performance. They should also be evaluated relative to the opportunity set of all portfolios that can be formed under the same mandate – the portfolio opportunity set. The distribution of performance values over the portfolio opportunity set depends on contemporary market dynamics. To correct for this, we suggest a normalized version of the information ratio that is invariant to these market conditions.

Keywords: Performance Evaluation, Benchmarking, Information Ratio, Tracking Error