Handbook of Finance: Investment Management and Financial Management

Chapter 32. Tracking Error and Common Stock Portfolio Management

RAMAN VARDHARAJ, CFA

Senior Quantitative Analyst, RS Investments

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

FRANK J. JONES, PhD

Professor of Finance, San Jose State University

Abstract: 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.

Keywords: tracking error, active return, alpha, information ratio, forward-looking tracking error, backward-looking tracking error, marginal contribution to tracking error

In this chapter, we describe the concept of tracking error, how it is computed, and identify some of the factors that affect tracking error. While tracking error applies to a portfolio for asset class, in this chapter we focus on tracking error for a common stock portfolio.

DEFINITION OF TRACKING ERROR

The risk of a portfolio can be measured by the standard deviation of portfolio returns. This statistical measure provides a range around the average return of a portfolio within which the actual return over a period is likely to fall with some specific probability. The mean return and standard deviation (or volatility) of a portfolio can be calculated over a period of time.

The standard deviation or volatility of a portfolio ...