Tracking Error and Tactical Asset Allocation

The relationship between statistical measures of tracking error and asset allocation restrictions expressed as admissible weight ranges is discussed. Tracking errors are typically calculated as annualized second moments of return differentials between a portfolio and a benchmark. In practice, however, constraints on tactical deviations from benchmark weights are often imposed on the portfolio manager to ensure adequate tracking. Simulating various investment strategies subject to such constraints, how the size of acceptable deviations from the benchmark relates to the statistical tracking error is presented. An example based on actual market data indicates that imposing fairly large tactical asset allocation ranges produces surprisingly small tracking errors. It was also found that TAA restrictions should restrict not only the tactical ranges of the individual asset classes but also, and perhaps even more importantly, the tracking of individual asset classes.

[http://www.manuel-ammann.com/pdf/PubsAmmann2001TrackingErrorFAJ.pdf]