The Relation between Tracking Error and Tactical Asset Allocation

In this paper we investigate the relation between statistical tracking error measures and assetallocation restrictions expressed as admissible weight ranges. Typically, tracking errors arecalculated as annual standard deviations of return differentials between tracking portfolio andbenchmark. In practice, however, constraints on tactical deviations from benchmark weightsare often imposed instead on the portfolio manager to ensure adequate tracking. Simulatingvarious investment strategies subject to such constraints, we illustrate how the size ofacceptable deviations from the benchmark relates to the statistical tracking error. Using anexample based on actual market data, we find that...