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Tracking Error



Definition

Tracking error is a measure used in finance to gauge how closely a portfolio follows the index to which it is benchmarked. It is calculated by subtracting the return of the index from the return of the portfolio. A low tracking error indicates the portfolio is closely mimicking the index, while a high tracking error shows the portfolio is deviating significantly from the index.

Phonetic

The phonetics of the keyword “Tracking Error” is: /ˈtrækɪŋ ˈɛrər/

Key Takeaways

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  1. Measurement of Deviation: Tracking error is commonly used as a measure of the deviation of an investment portfolio’s returns from those of its benchmark index. It essentially reflects the differential between the performance of the portfolio and its benchmark.
  2. Relates to Risk: The size of the tracking error gives an indication of the level of risk the fund or portfolio is taking compared to the benchmark. A lower tracking error means the manager is closely following the benchmark. A high tracking error means the fund is taking additional risk by not closely following the benchmark.
  3. Relation with Active and Passive management: Active managers typically have higher tracking errors than passive managers. That’s because active managers make purposeful deviations from the benchmark in an attempt to outperform, which can result in larger discrepancies between the performance of the portfolio and the benchmark.

Importance

Tracking error is an important concept in finance and business as it helps investors understand how well a fund is replicating the performance of a benchmark index. Essentially, tracking error is a measure of the disparity between the performance of an investment portfolio and its benchmark. This is critical information for investors because it indicates the fund manager’s skill in portfolio management. If the tracking error is high, it suggests that the fund is deviating significantly from the index, possibly due to active management strategies. On the other hand, a low tracking error indicates that the fund closely follows the index. Therefore, tracking error can be used as a risk measure to evaluate the potential deviation of the portfolio’s return from the expected return.

Explanation

Tracking error, in the context of finance and investing, is a measure used to gauge the performance of a particular investment strategy or a fund manager. When a fund manager employs an investment strategy, they often aim to ‘track’ or mirror the performance of a specific index, such as the S&P 500. However, discrepancies in performance can occur due to various reasons such as transaction fees, cash flows, or timing. The purpose of the tracking error is to quantify this deviation from the performance of the benchmark index — it serves as a risk metric to assess the consistency of a manager’s returns relative to their benchmark.Practically, an investor may use tracking error to gauge the risk associated with a specific investment strategy, and potentially use that information to make decisions about their portfolio. For instance, a fund with a high tracking error suggests a high discrepancy between the fund performance and the benchmark — this could indicate riskier bets being taken by the fund manager, or inefficiencies in the fund’s operations. Conversely, a low tracking error indicates the fund is closely following its target index. Hence, tracking error isn’t just seen as a measure of a fund’s “error” , but it is an important tool to evaluate fund manager’s performance and the risks attached with the investment strategy.

Examples

1. Vanguard 500 Index Fund: It’s a mutual fund designed to mimic the performance of the S&P 500 Index. If over the course of a year the S&P 500 Index provides a return of 8%, but the Vanguard 500 Index Fund only provides a return of 7.5%, there is a tracking error of 0.5%. This error is most likely caused by the fund’s operating expenses which decrease the returns that investors get.2. ETFs and Index Funds: Another example can be seen in ETFs and index funds tracking the performance of international markets. These funds aim to replicate the performance of a specific international index, but due to variations in exchange rates, time differences or changes in foreign laws and regulations, the performance of the fund might differ from the index it’s tracking, giving rise to a tracking error.3. Currency Hedged ETFs: For example, the Deutsche X-trackers MSCI EAFE Hedged Equity ETF (DBEF) which is designed to track the MSCI EAFE Index while hedging against fluctuations between the value of the U.S. dollar and the currencies of the countries included in the index. If the hedging strategy doesn’t perfectly match the currency fluctuations, then the ETF may experience a tracking error.

Frequently Asked Questions(FAQ)

What is tracking error in finance?

Tracking error is a discrepancy between a portfolio’s returns and the benchmark or index it was intended to mirror or track. It’s a measure of how closely a portfolio follows the index to which it is benchmarked.

How is the tracking error calculated?

The Tracking Error can be calculated by taking the standard deviation of the difference between the portfolio and benchmark returns.

Why is tracking error significant?

The tracking error is signifcant in finance as it provides a way to quantify the manager’s performance against their indexed benchmark. It is crucial for understanding the risk and volatility involved in an investment.

What factors can contribute to tracking error?

Factors such as differences in portfolio holdings, trading cost, fees, and cash drag, among others, can contribute to the tracking error.

Is a high tracking error good or bad?

A high tracking error is not necessarily bad, nor is a low tracking error necessarily good. It all depends on the risk tolerance of the investor and the extent to which the investor wants the fund to replicate the index returns.

Can tracking error be negative?

Yes, tracking error can be negative. A negative tracking error indicates that the portfolio returns are lagging behind the performance of the benchmark.

How does management fee affect tracking error?

A higher management fee negatively affects tracking error as it increases costs, dragging down the net return of the fund which thereby widens the gap between the fund and the benchmark’s return.

How does a portfolio manager reduce tracking error?

A portfolio manager can reduce tracking error by closely mirroring the benchmark’s sector weightings, frequently rebalancing the portfolio, or reducing trading and other costs.

How does tracking error relate to active management?

In active management, where the goal is to outperform a benchmark, a portfolio manager might purposely take on a higher tracking error in the belief that the added risk will generate greater returns.

: Can tracking error be used to estimate future risk?

Yes, tracking error can be used as a risk measure to understand the potential dispersion of future returns around the benchmark return, given the current portfolio structure. However, it cannot predict unforeseen market conditions or changes.

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