Abstract:
Maximising returns is often the primary goal of asset management but
managing and mitigating portfolio risk also plays a significant role. Successful active
investing requires outperformance of a benchmark through skillful stock selection
and market timing, but these bets necessarily give rise to risk. The risk, relative to
the benchmark, is the tracking error and active managers are constrained by
investment mandates including a restriction on tracking error. The locus of possible
portfolio risks and returns, constrained by a tracking error is elliptical, and the main
axis slope’s sign and magnitude varies under different market conditions. How
these variations affect portfolio performance is explored for the first time. We find
that changes in main axis slope (magnitude and sign) acts as an early indicator of
portfolio performance and could therefore be used as another risk management
tool.
