What is Tracking Error?
Tracking error is a measure of financial performance that determines the difference between the return fluctuations of an investment portfolio and the return fluctuations of a chosen benchmark. The return fluctuations are majorly measured by standard deviations.
Generally, a benchmark is a diversified market index that represents part of the total market. The most common benchmarks for equity portfolios are the S&P 500 and the Dow Jones Industrial Average (DJIA) for portfolios with large-cap stocks and Russell 2000 for small-cap portfolios.
Importance of Tracking Error
Tracking error is one of the most important measures used to assess the performance of a portfolio, as well as the ability of a portfolio manager to generate excessive returns and beat the market or the benchmark. Due to the abovementioned reasons, it is used as an input to calculate the information ratio.
Tracking error is frequently categorized by the way it is calculated. A realized (also known as “ex post”) tracking error is calculated using historical returns. A tracking error whose calculations are based on some forecasting model is called “ex ante” tracking error.
Low (tracking) errors indicate that the performance of the portfolio is close to the performance of the benchmark. The low errors are attributable to index funds and ETFs that replicate the composition of stock market indices.
High (tracking) errors reveal that the portfolio performance is significantly different from the performance of the benchmark. The high errors can indicate that the portfolio substantially beat the benchmark, as well as it can signal that the portfolio significantly underperforms the benchmark.
Formula for Tracking Error
The tracking error is calculated using the following formula:
- Var – the variance
- rp – the return of a portfolio
- rb – the return of a benchmark
Example of Tracking Error
Five years ago, Sam invested $100,000 in Fund A. The fund primarily invests in the large-cap US equities. During the five-year period, the fund showed positive returns. Also, the economy also grew during the period and equity markets rose.
In order to assess how successful was an investment, Sam decides to compare the returns of Fund A against the returns of a benchmark. In such a case, the most appropriate benchmark is the S&P 500, because it tracks the performance of the biggest large-cap companies.
The comparison of the fund against the benchmark can be measured using the tracking error.
The following data is available for the yearly returns for both the Fund A and the S&P 500:
We can plug this data into the formula to calculate the tracking error:
In the scenario above, the small tracking error indicates that the Fund A does not significantly outperform the benchmark. Therefore, Sam may consider withdrawing his money from the fund and putting them in other investment opportunities.
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