actively strongmanagingstrong tracking error - northwestern university.pdfVIP

Actively managing tracking error Received: 12th October, 2004 Curt Burmeister is a director in the Buy-Side Group at Algorithmics Incorporated. In his current role, he is responsible for product design, business strategy and partner relationships. He holds an MBA in financial engineering from MIT and a BA in computer science and mathematics from Cornell University. Helmut Mausser* is a senior mathematician at Algorithmics Incorporated, where he develops methods and models for risk management. He holds a PhD in Operations Research from the University of Colorado. Rafael Mendoza is a doctoral student of industrial engineering and management science at Northwestern University. Previously, he was a financial engineer at Algorithmics Incorporated. He holds a Master’s degree in mathematical finance from the University of Toronto. *Algorithmics Incorporated, 185 Spadina Avenue, Toronto, Canada M5T 2C6 Tel: 1 416 2171500; Fax: 1 416 9716100; e-mail: hmausser@ Abstract Managing tracking error on an ex ante basis requires an ability to assess the possible effects of trades on a fund’s performance relative to its benchmark. This paper develops several simple diagnostic tools to help fund managers evaluate alternative trading strategies in terms of their potential for reducing tracking error. Moreover, risk reductions can be readily balanced against trading requirements and impacts on active return to identify desirable strategies. Keywords: tracking error, risk management, trading strategies, risk decomposition, ex ante, trade risk profile Introduction receives limited consideration in the