IMPACT OF NON-LINEAR VOLATILITY IN STOCK-SPECIFIC RISK ON THE TURNOVER OF ACTIVELY MANAGED PORTFOLIOS
IMPACT OF NON-LINEAR VOLATILITY IN STOCK-SPECIFIC RISK ON THE TURNOVER OF ACTIVELY MANAGED PORTFOLIOS

Author(s): Plamen Patev, Kaloyan Petkov
Subject(s): Economy, Business Economy / Management, Human Resources in Economy
Published by: Udruženje ekonomista i menadžera Balkana
Keywords: turnover;non-linear risk;transaction costs;alpha;
Summary/Abstract: Active investment has been established as one attractive approach for portfolio management. In order to achieve additional return – alpha, it requires investors to rebalance their portfolios often and to apply it for broader set of assets. However, as a result of such strategy portfolios could be exposed to an enormous turnover which leads to higher transaction costs. In many cases models with proven high-quality fail to provide the projected alpha because of alpha decaying caused by transaction costs of high turnover. Our paper is aimed to give more details about influence of stock-specific risk on turnover of active investments. We find that the ratio between target tracking error of the portfolio and stock-specific risk of an important factor in establishing the optimum turnover (and transaction costs). We investigate how this ratio is related with the turnover and how it influences the portfolio optimization process. We prove that changes in stock-specific risk causes managers to rebalance their portfolios in order to achieve their target tracking error. It is shown that these changes occur due to the non-linearity of stock volatility. We use GARCH model to measure the impact of short-term volatility shocks on the turnover of portfolio. Our findings confirm the importance of non-linear volatility for active portfolio turnover. Furthermore, we present empirical example for keeping turnover in desired level by adjusting the target tracking error of the factor portfolio.

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