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Declining Active Risk in Japanese Equity Portfolios

Since the collapse of the Internet bubble, many Japanese portfolio managers have observed a surprising contrast between trends in tracking error and market volatility: tracking errors have fallen dramatically for many portfolios, while the volatility of the TSE1 index has declined much more gradually.  The decrease in tracking error is related to a phenomenon occurring in markets around the globe.  The cross-sectional dispersion of asset returns within these markets is much smaller today than it was a few years ago.  The low level of cross-sectional dispersion makes the art of active portfolio management more difficult than it was before.  It demands a considered response from managers.