Are asset managers properly using tracking error estimates?
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Raffaele Zenti* has been Risk Manager at Ras Asset Management since 1997. He works on the development of the internal risk model and on the definition and application of risk policies to actively managed portfolios. He studied Economics and Statistics in Turin and is lecturer at the Master of Finance of CORIPE, University of Turin.
Massimiliano Pallotta joined the Risk Management team of Ras Asset Management in 1997, working on the quantitative and technological aspects of the development of the company’s internal model. He studied Mathematics in Milan and he has practical experience on the technological aspects of the risk management process.= *Ras Asset Management SGR, Piazza Velasco 7/9. 20122 Milan, Italy Tel: ⫹39 02 802 00 506; Fax: ⫹39 02 802 00 239; e-mail: [email protected]
Abstract In the investment community, tracking error is often regarded as the single most important risk measure, and many active asset management companies use tracking error as a basis for keeping a portfolio’s relative risk under control. Recently, the investment community has become aware of some shortfalls of tracking error. One of the main pitfalls is that ex-ante and ex-post tracking errors differ, since portfolio weights are stochastic and market drivers have changing distributions. This conclusion can be extended to other risk indicators, eg relative value at risk. This paper shows that, if portfolio managers follow a risk policy and on a regular basis they keep their portfolio relative risk in a given range, ex-ante tracking error does not differ in a statistical sense from ex-post tracking error, and the stochastic nature of portfolio weights becomes almost irrelevant. Therefore, if the goal is to avoid wrong measurement of tracking error and subsequent troubles with clients, the main focus of active asset management companies should be on two points: (i) forecasting risk correctly; (ii) implementing a risk policy on a regular basis. Keywords: asset management; risk management; investment risk; tracking error; risk policy
Introduction Tracking error (TE) is used routinely among asset managers. Pension funds and other institutional investors increasingly pay attention to risk budgeting and define mandates’ limits of risk on the basis of TE, demanding improved risk reporting from asset managers. In
䉷 Henry Stewart Publications 1479-179X (2002)
addition, management fees paid by sponsors are sometimes linked in some way to realised TE. Recently, many risk models commonly used by asset managers have seriously underestimated the TE exhibited by investors’ portfolios. There could be several explanations for this phenomenon.
Vol. 3, 3, 279-289
Journal of Asset Management
279
Zenti and Pallotta
Pope and Yadav (1994) demonstrate that serial correlation in the time series of excess returns can cause an underestimation of TE, if it is not properly taken into account. Scowcroft and Sefton (2001) compare ex-ante and ex-post TE over an investment horizon of up to one year, considering portfolios that are not actively manage
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