Active Portfolio Management with Conditional Tracking Error

Institutional investment decisions are generally centered around mandates, where a manager’s deviation from the benchmark is controlled by means of a tracking error volatility (TEV) constraint. This constraint is of absolute nature: once imposed, it should be honored irrespective of market developments. In this paper, we introduce the concept of a dynamic or conditional TEV constraint. In this set-up, a manager’s active risk budget is tied in a relative sense to the benchmark volatility level and hence relative to the cross-sectional dispersion in the returns on the underlying securities. Such a budgeting of risk allows for controlling a manager’s active risk exposure vis à vis changing market conditions. When the opportunities in the market are widening, a conditional TEV constraint offers a manager
the additional room to “hunt” for value and to outperform. Also when there is a surprise or shock in the volatility of the benchmark, a conditional TEV constraint will not hold the manager responsible for the increase in overall volatility. Likewise, a conditional TEV constraint will prevent a manager to deviate too much from his benchmark in a stable (i.e. dull) market, thus mitigating the risk of blow-ups.
Keywords: Benchmarking; Tracking Error; Risk Budgeting; Cross-section; Dispersion.
JEL Codes: C15; C43; G11.