Markus Aakko, Andrew F. Pyne
The art of pension plan management consists of skillful plan design, asset allocation, investment selection, implementation and risk management. Most plans use multiple investment managers to attain a proper degree of diversification, and selecting those managers takes a lot of time and typically requires expert, external advice. The process does not end with selection, however: Managers must be monitored on performance, risk, process and style in order to confirm that they are performing their role in the overall portfolio construction. The methods employed to carry out that monitoring are well established. But given the importance of getting portfolio allocation right in a low-growth, low-return world, it’s worth examining whether there are new ways of thinking about and assessing whether and how a manager adds value beyond a passive benchmark. Tracking errorTraditionally, pension plan managers and consultants have used tracking error (TE) to monitor the active risk their appointed asset managers take. Tracking error is the standard deviation of periodic excess returns above or below a benchmark index, usually measured either daily or monthly (see Figure 1). The theory is that if a given manager usually posts a tracking error within a certain range – say 300 to 500 basis points – a deviation above or below this range may be a sign of change in the manager’s risk posture and potentially even its portfolio management style. (To be sure, there are a number of ways to measure how a manager stacks up to a benchmark, including the portfolio’s risk factor exposures. The analysis in this article focuses on historical tracking error as well as a complementary measure.)
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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