Optimal allocation depends primarily on which two factors?

Optimal allocation in an investment context is heavily influenced by the information ratio and tracking error, making these two factors crucial for effective portfolio management.

The information ratio measures the return of a portfolio relative to its benchmark, adjusted for risk. It quantifies how much excess return is being generated per unit of risk. A higher information ratio indicates a more efficient portfolio, as it suggests that the investment manager is generating a significant return on their active management while taking on an acceptable level of risk.

Tracking error, on the other hand, is the standard deviation of the difference between the portfolio's returns and those of its benchmark. It reflects the volatility of the portfolio's relative return, providing insight into how consistently the portfolio follows its benchmark. Low tracking error suggests that the portfolio closely follows the benchmark, while high tracking error indicates more deviation and potential for higher returns or risks.

By considering both the information ratio and tracking error, investors can optimize their allocation by maximizing returns while managing the risk associated with deviations from the benchmark. Together, these factors help in making informed decisions to achieve desired investment outcomes, ensuring that the portfolio aligns with the investor's risk appetite and performance objectives.