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Dynamic Volatility and its Implications for Portfolio Management

A discussion on the implications of changing volatility levels on active and passive portfolio management. In the Summer 2005 Horizon Newsletters, we examined the sources of cross-sectional volatility in the Japan market. We extend the study to Europe and the US market and simulate the impact of dynamically changing volatility levels on active portfolio risk. We show that the optimal level of tracking error, the size of active exposures, and the optimal number of securities vary wildly with changing volatility levels.