Persistent bear market conditions have led to a shift of focus in the tracking error literature. Until recently the portfolio allocation literature focused on tracking error minimization as a consequence of passive benchmark management under portfolio weights, transaction costs and short selling constraints. Abysmal benchmark performance shifted the literature's focus towards active portfolio strategies that aim at beating the benchmark while keeping tracking error within acceptable bounds. We investigate an active (dynamic) portfolio allocation strategy that exploits the predictability in the conditional variance-covariance matrix of asset returns. To illustrate our procedure we use Jorion's (2002) tracking error frontier methodology. We apply our model to a representative portfolio of Australian stocks over the period January 1999 through November 2002.
Ammann, M. & Zimmermann, H.2001, ‘Tracking error and tactical asset allocation’,Financial Analysts Journal, vol. 57, pp. 32–43.
2.
Blair, B.2002, ‘Conditional asset allocation using prediction intervals to produce allocation decisions’,Journal of Asset Management, vol. 2, pp. 325–35.
3.
Blasco, N. & Santamaria, R.2001, ‘Highest-density forecast regions: An essay in the Spanish stock market’,Journal of Asset Management, vol. 2, pp. 274–83.
4.
Campbell, R., Huisman, R. & Koedijk, K.2001, ‘Optimal portfolio selection in a value-at-risk framework’,Journal of Banking and Finance, vol. 25, pp. 1789–804.
5.
Chan, L. K. C. & Lakonishok, J.1993, ‘Are the reports of beta‘s death premature?’,Journal of Portfolio Management, vol. 19, pp. 51–62.
6.
Chan, L. K. C., Karceski, J. & Lakonishok, J.1999, ‘On portfolio optimization: Forecasting covariances and choosing the risk model’,Review of Financial Studies, vol. 12, pp. 937–74.
7.
Clarke, R., de Silva, H. & Thorley, S.2002, ‘Portfolio constraints and the fundamental law of active management’,Financial Analysts Journal, vol. 58, pp. 48–66.
8.
Elton, E. J., Gruber, M. J., Brown, S. J. & Goetzmann, W. N. 2003, Modern Portfolio Theory and Investment Analysis, John Wiley & Sons, New York.
9.
Engle, R. F.1982‘Autoregressive conditional heteroskedasticity with estimates of the variance of UK inflation’,Econometrica, vol. 50, pp. 987–1008.
10.
Frino, A. & Gallagher, D. R.2001, ‘Tracking S&P 500 Index funds,Journal of Portfolio Management, vol. 28, pp. 44–55.
11.
Grinold, R. C. & Kahn, R. N. 1999, Active Portfolio Management, 2nd edition, McGraw-Hill, New York.
12.
Jansen, R. & van Dijk, R.2002, ‘Optimal benchmark tracking with small portfolios’,Journal of Portfolio Management, vol. 29, pp. 33–9.
13.
Jorion, P. 2002, ‘Portfolio optimization with constraints on tracking error’, Financial Analysts Journal, forthcoming.
14.
Kritzman, M.1987, ‘Incentive fees: Some problems and some solutions’,Financial Analysts Journal, vol. 43, pp. 21–6.
15.
Larsen, G. A. & Resnick, B. G.1998, ‘Empirical insights on indexing’,Journal of Portfolio Management, vol. 25, pp. 27–34.
16.
Larsen, G. A. & Resnick, B. G.2001, ‘Parameter estimation techniques, optimization frequency, and portfolio return enhancement’,Journal of Portfolio Management, vol. 28, pp. 27–34.
17.
Lawton-Browne, C.2001, ‘An alternative calculation of tracking error’,Journal of Asset Management, vol. 2, pp. 223–34.
18.
Plaxco, L. M. & Arnott, R. D.2002, ‘Rebalancing a global policy benchmark’,Journal of Portfolio Management, vol. 29, pp. 9–22.
19.
Pope, P. & Yadav, P. K.1994, ‘Discovering the error in tracking error’,Journal of Portfolio Management, vol. 21, pp. 27–32.
Rohweder, H. C.1998, ‘Implementing stock selection ideas: Does tracking error optimization do any good?’,Journal of Portfolio Management, vol. 25, pp. 49–59.
22.
Roll, R.1992, ‘A mean/variance analysis of tracking error’,Journal of Portfolio Management, vol. 18, pp. 13–22.
23.
Rosenberg, B.1985, ‘Prediction of common stock betas’,Journal of Portfolio Management, vol. 11, no. 2, pp. 5–14.
24.
Rosenberg, B. & Guy, J.1976, ‘Beta and investment fundamentals’,Financial Analysts Journal, vol 32, pp. 60–72.
25.
Rudd, A.1980, ‘Optimal selection of passive portfolios’,Financial Management, vol. 4, pp. 57–66.
26.
Rudd, A. & Rosenberg, B.1980, ‘The ‘Market Model‘ in investment management’,Journal of Finance, vol. 35, pp. 597–606.
27.
Rudolf, M., Wolter, H-J. & Zimmermann, H.1999, ‘A linear model for tracking error minimization’,Journal of Banking and Finance, vol. 23, pp. 85–103.
28.
Satchell, S. E. & Hwang, S.2001, ‘Tracking error: Ex-ante versus ex-post measures’,Journal of Asset Management, vol. 2, pp. 241–46.
29.
Scowcroft, A. & Sefton, J.2001, ‘Do tracking errors reliably estimate portfolio risk?’,Journal of Asset Management, vol. 2, pp. 205–22.
30.
Timmermann, A. & Blake, D. 2002, ‘International asset allocation with time-varying investment opportunities’, Journal of Business, Forthcoming.
31.
Treynor, J. & Black, F.1973, ‘How to use security analysis to improve portfolio selection’,Journal of Business, vol. 46, pp. 66–86.
32.
Zenti, R. & Pallotta, M.2002, ‘Are asset managers properly using tracking error estimates?’,Journal of Asset Management, vol. 3, pp. 279–89.
