Tracking Error Primer
Understanding the dimensions of risk is critical to both constructing a portfolio and evaluating managers. The goal of this research brief is to provide a deeper understanding of one particular dimension of portfolio risk: tracking error.
One way to measure the risk of a portfolio is on an absolute basis – in other words, not in comparison to a benchmark. The most common measure of a portfolio’s absolute risk is standard deviation, which measures the volatility of the portfolio’s returns.
Portfolio risk is also frequently measured relative to a benchmark. Tracking error is a commonly used gauge of benchmark risk, and is closely associated with excess return. A portfolio’s excess returns are simply the absolute difference between a portfolio’s return and that of its benchmark. Technically, tracking error is the annualized standard deviation of a portfolio’s excess returns. In practice, tracking error is a gauge of how consistently a portfolio outperforms, or underperforms, its benchmark. The lower the tracking error, the more closely the portfolio mimics its benchmark’s performance. The higher the tracking error, the more the portfolio deviates from the benchmark.
Tracking error is sometimes referred to as “active” risk, because it measures the active decision by the portfolio manager to veer from the benchmark’s holdings and position weights. However, tracking error is not confined to traditional actively managed portfolios in which the portfolio manager attempts to add value through security selection or implementing tilts such as sector over- or underweights. Passively managed portfolios such as index funds and ETFs also exhibit tracking error for several reasons, including situations in which the fund does not hold all of the index’s constituents in exactly the same weights as the index.
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