Equity Valuation and Portfolio Management

KEY POINTS

• Tracking error is a key concept in understanding the potential performance of a common stock portfolio relative to a benchmark index and the actual performance of a common stock portfolio relative to a benchmark index.
• Tracking error can be used to measure the degree of active management by a portfolio manager.
• Tracking error measures the variation of a portfolio's active return (i.e., the difference between the portfolio return and the benchmark return).
• Backward-looking tracking error or ex post tracking error is tracking error calculated from historical active returns; it will have little predictive value and can be misleading regarding portfolio risks going forward.
• A portfolio manager used forward-looking tracking error to estimate portfolio risk going forward.
• The information ratio, found by dividing alpha (i.e., the average active return over a time period) by the backward tracking error, is a reward-to-risk ratio.
• As the portfolio differs from its benchmark index in terms of the number of stocks held, their average market caps, sector allocations, and beta, its tracking error rises. Tracking error also rises in volatile markets.
• For a portfolio manager, the risk of heavily underperforming or outperforming the benchmark rises as the tracking error increases. Thus tracking error is an important indicator of portfolio performance and should be monitored frequently.