Equity Valuation and Portfolio Management

COMPONENTS OF TRACKING ERROR

There are two distinct approaches to portfolio selection. The first is a top-down approach. Here the manager tries to pick broad economic themes, such as sectors, style, size, and the like, which are likely to outperform in the coming periods and holds stocks that are consistent with the chosen theme. The second is a bottom-up approach, where the manager picks each individual stock in the portfolio on its own merit.

Insofar as the themes or stocks emphasized in the portfolio differ from those in the benchmark (through overweights and underweights), there will be a tracking error. We can then view the tracking error as arising partly from the theme-picking and partly from the stock-picking.

Since top-down managers believe they can add value mainly through discerning trends in returns associated with broad themes, they may want to reduce the portion of their portfolio's tracking error that arises from stock-specific reasons.

Bottom-up managers believe it is difficult, if not impossible, to forecast trends in themes. Returns associated with such broad themes tend to be volatile and this can amplify mistakes. Such managers believe it is more prudent to place a lot of small bets via stock selection than to place a few large bets via theme selection. Bottom-up managers would, therefore, seek to reduce the portion of the tracking error of their portfolios that comes from theme-specific reasons.

To answer the needs of these two types of managers, it would be ...