Chapter 10Benchmarks and the Use of Tracking Error in Portfolio Construction

Expected portfolio return maximization under the mean-variance framework introduced in Chapter 8 is an example of an active investment strategy—a strategy that identifies a universe of potentially attractive investments and ignores inferior investments opportunities. As we mentioned in Chapter 1, a different approach to investing, referred to as a passive investment strategy, or indexing, argues that in the absence of any superior forecasting ability, investors might as well resign themselves to the fact that they cannot outperform the market after adjusting for transaction costs and management fees. From a theoretical perspective, the analytics of portfolio theory tell investors to hold a broadly diversified portfolio. Hence, many mutual funds and equity portfolios are managed relative to a particular benchmark, market index, or stock universe, such as the S&P 500 or the Russell 1000. Bond portfolios are also benchmarked against fixed income indexes with particular characteristics regarding credit quality and maturity. For benchmarked portfolios, portfolio risk is evaluated based on the standard deviation of the portfolio deviations from the benchmark, or the tracking error, rather than the portfolio's overall standard deviation.

The selection of a benchmark is very important for effective portfolio management, and we spend a substantial amount of time in this chapter discussing the types of indexes ...

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