The idea is to test, practically, whether investors would benefit from Jorion’s (2003) proposal, especially in challenging market conditions. This article explores the effectiveness of Jorion’s (2003) proposal is in a practical situation by using a standard combination of equities and bonds in both bull and bear market conditions. Jorion (2003) noted that the shape of the ellipse was relatively flat therefore, the reduction in expected return should be marginal. However, Jorion’s (2003) suggestion of limiting the absolute risk of the portfolio to that of the benchmark would produce a portfolio with a lower coefficient of variation, thus optimising the portfolio in a mean-variance sense. This suggests that portfolio managers would essentially create a portfolio that lies on the uppermost point of this ellipse. Portfolio managers will ideally try to maximise the portfolio’s return, even if this incurs extra risk. This frontier is an ellipse in mean/variance space, and which identifies a portfolio’s permissible return/risk profile given a TE constraint. Jorion (2003) developed a constant TE frontier which incorporated the risk of the benchmark. Higher information ratios could indicate higher excess returns but could also indicate an increase in absolute risk ( Jorion, 1992). Other performance metrics such as the information ratio (a performance measure which does not account for total risk, only relative risk - see equation (1) - and is generally used ex-post performance) also ignores investors’ overall portfolio risk and exacerbate agency issues: Many investors incorrectly believe or assume that a higher TE is associated with a higher potential return, which may not always be true ( Thomas et al., 2013). TE is directly agnostic: it only determines the deviation of excess returns but articulates essentially nothing with regards to the direction of returns (e.g. Investors thus enforce a TE constraint, but this can result in portfolio managers focusing only on optimising excess returns and ignoring an investor’s overall portfolio risk ( Roll, 1992). Portfolio managers pursue positive returns that are above the benchmark, while simultaneously adhering to mandated constraints as they have an incentive to outperform the benchmark to earn additional revenue from performance fees. Generally, TE results from security selection, taxes, factor tilts, transaction costs, cash management and general market volatility ( Thomas et al., 2013). In practice, TE gauges how consistently a portfolio outperforms or underperforms its designated benchmark, and it is used in conjunction with several other metrics to evaluate a portfolio’s performance, such as the value at risk and information ratio. TE is an active risk measure that stipulates the standard deviation of the difference between the portfolio return and the benchmark return (or excess return). Within the asset management sector, tracking error (TE) is a fundamental performance evaluation measure that has been used by the industry to ensure portfolio managers adhere to their given investment policy statement (IPS).
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