The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

TRACKING ERROR AND RELATED MEASURES

Tracking error is a key concept in understanding the potential performance of a common stock portfolio relative to a benchmark index, as well as 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.

Definition of Tracking Error

As explained in Chapter 3, a portfolio’s risk can be measured by the standard deviation of portfolio returns. This statistical measure provides a range around the portfolio’s average return 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 or a market index is an absolute number. A portfolio manager or client can also ask what the variation of the portfolio’s return is relative to a specified benchmark. Such variation is called the portfolio’s tracking error.

Specifically, tracking error measures the dispersion of a portfolio’s returns relative to the benchmark’s returns. That is, tracking error is the standard deviation of the portfolio’s active return where active return is defined as

Active return = Portfolio’s actual return − Benchmark’s actual return

A portfolio created to match the benchmark (i.e., an index fund) that regularly has zero active returns (that is, always matches its ...