Active Risk Tracking Error
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it indicates how closely a portfolio follows the index to which it is benchmarked. The best measure is the standard deviation tracking error formula of the difference between the portfolio and index returns. Many portfolios are tracking error information ratio managed to a benchmark, typically an index. Some portfolios are expected to replicate, before trading and other costs,
Tracking Error Interpretation
the returns of an index exactly (e.g., an index fund), while others are expected to 'actively manage' the portfolio by deviating slightly from the index in order to generate
Annualized Tracking Error
active returns. Tracking error is a measure of the deviation from the benchmark; the aforementioned index fund would have a tracking error close to zero, while an actively managed portfolio would normally have a higher tracking error. Thus the tracking error does not include any risk (return) that is merely a function of the market's movement. In addition to risk tracking error volatility (return) from specific stock selection or industry and factor "bets," it can also include risk (return) from market timing decisions. Dividing portfolio active return by portfolio tracking error gives the information ratio, which is a risk adjusted performance measure. Contents 1 Definition 1.1 Formulas 1.2 Interpretation 2 Examples 3 References 4 External links Definition[edit] If tracking error is measured historically, it is called 'realized' or 'ex post' tracking error. If a model is used to predict tracking error, it is called 'ex ante' tracking error. Ex-post tracking error is more useful for reporting performance, whereas ex-ante tracking error is generally used by portfolio managers to control risk. Various types of ex-ante tracking error models exist, from simple equity models which use beta as a primary determinant to more complicated multi-factor fixed income models. In a factor model of a portfolio, the non-systematic risk (i.e., the standard deviation of the residuals) is called "tracking error" in the investment field. The latter way to compute the tracking error complements the formulas below but results can vary (sometimes by a fact
the benchmark or index it was meant to mimic or beat. Tracking error is sometimes called active risk. There are two ways to measure tracking
Tracking Error Cfa
error. The first is to subtract the benchmark's cumulative returns from annualised tracking error the portfolio's returns, as follows: Returnp - Returni = Tracking Error Where: p = portfolio i = index ex ante tracking error calculation excel or benchmark However, the second way is more common, which is to calculate the standard deviation of the difference in the the portfolio and benchmark returns over time. https://en.wikipedia.org/wiki/Tracking_error The formula is as follows: How it works (Example): Let's assume you invest in the XYZ Company mutual fund, which exists to replicate the Russell 2000 index, both in composition and in returns. If the XYZ Company mutual fund returns 5.5% in a year but the Russell 2000 (the benchmark) returns 5.0%, then using the first formula http://www.investinganswers.com/financial-dictionary/mutual-funds-etfs/tracking-error-4970 above, we would say that the XYZ Company mutual fund had a 0.5% tracking error. As time goes by, there will be more periods during which we can compare returns. This is where the second formula becomes more useful. The consistency (or inconsistency) of the "spreads" between the portfolio's returns and the benchmark's returns is what allows analysts to try to predict the portfolio's future performance. If, for example, we knew that the portfolio's annual returns were 0.4% higher than the benchmark 67% of the time during the last five years, we would know that this would probably be the case going forward (assuming the portfolio manager made no major changes). The predictive value of these calculations gets even better when there are more data points and when the analyst accounts for how the portfolio's securities move relative to one another (this is called co-variance). Several factors generally determine a portfolio's tracking error: 1. The degree to which the portfolio and the benchmark have securities in common 2. Differences
returns and the benchmark or index it was meant to mimic or beat. There are two ways to measure active risk. The first is to subtract the benchmark’s cumulative returns from the portfolio’s returns, as follows: Returnp - Returni http://www.investinganswers.com/financial-dictionary/investing/active-risk-5544 = Active Risk Where: p = portfolio i = index or benchmark However, the second way is more common, which is to calculate the standard deviation of the difference in the the portfolio and benchmark returns over time. The formula is as follows: How it works (Example): Let’s assume you invest in the XYZ Company mutual fund, which exists to replicate the Russell 2000 index, both in composition and in returns. If tracking error the XYZ Company mutual fund returns 5.5% in a year but the Russell 2000 (the benchmark) returns 5.0%, then using the first formula above, we would say that the XYZ Company mutual fund had a 0.5% active risk. As time goes by, there are more periods during which we can compare returns. This is where the second formula becomes more useful. The consistency (or inconsistency) of the “spreads” between the portfolio’s active risk tracking returns and the benchmark’s returns are what allow analysts to try to predict the portfolio’s future performance. If, for example, we knew that the portfolio’s annual returns were 0.4% higher than the benchmark 67% of the time during the last five years, we would know that this would probably be the case going forward (assuming the portfolio manager made no major changes). The predictive value of these calculations gets even better when there are more data points and when the analyst accounts for how the portfolio’s securities move relative to one another (this is called covariance). Several factors generally determine a portfolio’s active risk: The degree to which the portfolio and the benchmark have securities in common Differences in market capitalization, timing, investment style and other fundamental characteristics of the portfolio and the benchmark Differences in the weighting of assets between the portfolio and the benchmark The management fees, custodial fees, brokerage costs and other expenses affecting the portfolio that don’t affect the benchmark The volatility of the benchmark The portfolio’s beta Further, portfolio managers must accommodate inflows and outflows of cash from investors, which forces them to rebalance their portfolios from time to time. This too involves direct and indirect costs. Why it Matters: Low active risk means a portfolio closely fol
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