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The notion of benchmark as well as tracking error have pervaded the asset management industry in such a way that, lets say, any plain vanilla asset manager as well as any fund has its benchmark. Even though, Hedge Funds often have no market-based benchmarks, Hurdle rates as well as High-watermark provisions are implicit benchmarks. In that respect, Goetzmann et al.( 2003) discuss the path-dependent option-like features generated by High-watermark provisions. A plain vanilla, lets say, active fund manager could be compensated as a function of alpha generated under the constraint on the tracking error variance with respect to the benchmark.
Incidentally, this bears the question of the inadequacy of the benchmark, an issue highlighted by Sensoy (2009)....
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