Tracking Error is the divergence between the price behavior of the position of the portfolio and the price behavior of the benchmark. It indicates how closely a portfolio follows the index to which it is benchmarked. It is in the context of the mutual fund, hedge fund, or ETF (Exchange Traded Fund) which did not work as effectively as intended. It is mostly categorized as it is calculated. A realized Tracking Error is calculated using Historical returns. It is also known as “ex-post “. A tracking error whose calculations are based on forecasting is an “ex-ante” tracking error. Low Tracking Errors will indicate that the performance of the portfolio is close to the performance of the benchmark and high Tracking Errors will indicate that the performance of the portfolio is far from the performance of the benchmark.
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How it is calculated?
It is the difference between the Standard Deviations of the portfolio and the benchmark.
Tracking Error = Standard Deviation of (P – B)
Where P is portfolio return and B is benchmark return.
Assume that there is a large capital mutual fund Benchmarked to the S&P 500 index and that the mutual fund and the index realized the following returns over a given five-year period:
|Mutual funds||S & P 500|
The series of differences is then (11% – 12%), (3% – 5%), (12% – 13%), (14% – 9%) and (8% – 7%). These differences equal -1%, -2%, -1%, 5%, and 1%. The standard deviation of this series of differences, the tracking error, is 2.79%.
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It is an important measure to assess the performance of a portfolio and the ability of a manager to generate returns.
- It helps convert the difference between an investment portfolio and a concerned benchmark into a one digit-number for better comparison and understanding.
- Helps to ascertain how close the portfolio is to the benchmark
- It helps the manager to make a correct decision.
- It shows how good the manager’s investment strategy is.
- The investor can easily know the differences between the returns of the benchmark and the portfolio.
As there are benefits there are limitations to it as well too.
It is used widely to measure and to compare the underperformance and the over the performance of the portfolio and the benchmark. Investors prefer a high tracking error when there is overperformance and a low tracking error when there is underperformance by the investors. But, generally, it does not help distinguish between this in the right way.
Author – Saachi Lodha
About the Author – A passionate professional with knowledge of Accounting and Finance and currently exploring Financial Risk Management (FRM) to gain knowledge and exposure. As a part of the FRM course also writing blogs to explore the field more and deep dive into the content.