Define Investment Tracking Error
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Tracking Error Definition
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Tracking Error Meaning
Trade with a starting balance of $100,000 and zero risk! FX Trader Trade the Forex market risk free using our free Forex trading simulator. Advisor Insights Newsletters Site Log In Advisor Insights Log In Tracking Error Loading the player... What is a 'Tracking Error' Tracking error is the divergence between portfolio tracking error the price behavior of a position or a portfolio and the price behavior of a benchmark. This is often in the context of a hedge or mutual fund that did not work as effectively as intended, creating an unexpected profit or loss instead.Tracking error is reported as a standard deviation percentage difference, which reports the difference between the return an investor receives and that of the benchmark he was attempting to imitate. BREAKING DOWN 'Tracking Error' Since portfolio risk is often measured against a benchmark, tracking error is a commonly used metric to gauge how well an investment is performing. Tracking error shows an investment's consistency versus a benchmark over a given period of time. Even portfolios that are perfectly indexed against a benchmark behave differently than the benchmark, even though this difference on a day-to-day, quarter-to-quarter or year-to-year basis may be ever so slight. Tracking error is used to quantify this difference.Calculation of Tracking ErrorTracking error is the standard deviation of the difference between the returns of an investment and its benchmark. Given a sequence of return
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 error. The first is to subtract the benchmark's cumulative returns from the portfolio's returns, as follows:
Fund Tracking Error
Returnp - Returni = Tracking Error Where: p = portfolio i = index or benchmark
Mutual Fund Tracking Error
However, the second way is more common, which is to calculate the standard deviation of the difference in the the portfolio and index fund tracking error 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. http://www.investopedia.com/terms/t/trackingerror.asp 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 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 http://www.investinganswers.com/financial-dictionary/mutual-funds-etfs/tracking-error-4970 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 in market capitalization, timing, investment style, and other fundamental characteristics of the portfolio and the benchmark 3. Differences in the weighting of assets between the portfolio and the benchmark 4. The management fees, custodial fees, brokerage costs and other expenses affecting the portfolio that don't affect the benchmark 5. The volatility of the benchmark 6. 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 tracking error means a portfolio is clos
CFA Program CFA Forums CFA General Discussion CFA Level I Forum CFA Level II Forum CFA Level III Forum CFA Hook Up CAIA More in CAIA CAIA http://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/9675527 Test Prep CAIA Events CAIA Links About the CAIA Program FRM More in FRM FRM Test Prep FRM Events FRM Links About the FRM Program Careers Investments Water Cooler Test Prep Test Prep Sections CFA Test Prep CAIA Test Prep FRM Test Prep Calendar AF Deals CFA Test Prep CFA Events CFA Links About the CFA Program Home Forums CFA Forums CFA Level II Forum Tracking error vs Tracking tracking error risk Tweet Widget Google Plus One Linkedin Share Button Facebook Like Last post Bradleyz Mar 27th, 2008 3:46pm 412 AF Points If you look up “tracking error” on wikipedia, it says “It measures the standard deviation of the difference between the portfolio and index returns. In the curriculum, “tracking error” is also known as “active return” and is defined as the difference between the return on the portfolio vs the fund tracking error benchmark. There is no standard deviation mentioned in this definition. On the other hand, if you look up “tracking risk” in wikipedia, it doesn’t give anything, but if you look up “active risk”, which according to CFA is another workd for “tracking risk”, it says it “is defined as the annualized standard deviation of the monthly difference between portfolio return and benchmark return. In the curriculum, “tracking risk” is defined as the standard deviation of the active return. It is broken into 2 parts, active factor risk (such as over or under weighting industries) and active specific risk (such as specific stocks). My question is, wouldn’t portfolio managers consider minimizing specific components of tracking risk and not tracking error? I could understand that a PM may not want to bet too heavily on a few industries so that the benchmark is no longer applicable. I do not understand why they’d want to reduce the tracking error (active return), which is the difference between their returns and the index. After all, isn’t that what they’re getting paid to do? The reason I’m asking is because I’ve come across 2 cases while reading about the portfolio mangers strategies where they’ve said they want to keep “tracking error” below a