Define Tracking Error
Contents |
the benchmark or index it was meant to mimic or beat. Tracking error is sometimes called active risk. There are two ways to measure define information ratio tracking error. The first is to subtract the benchmark's cumulative returns define sharpe ratio from the portfolio's returns, as follows: Returnp - Returni = Tracking Error Where: p = portfolio
Define Alpha
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
Define Beta
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 the XYZ Company mutual fund returns 5.5% in a year but the Russell 2000 (the benchmark) returns 5.0%, then define r squared 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 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
it indicates how closely a portfolio follows the index to which it is benchmarked. The best
Define Standard Deviation
measure is the standard deviation of the difference between the portfolio high tracking error and index returns. Many portfolios are managed to a benchmark, typically an index. Some portfolios are expected interpreting tracking error to replicate, before trading and other costs, the returns of an index exactly (e.g., an index fund), while others are expected to 'actively manage' the portfolio by http://www.investinganswers.com/financial-dictionary/mutual-funds-etfs/tracking-error-4970 deviating slightly from the index in order to generate 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 https://en.wikipedia.org/wiki/Tracking_error (return) that is merely a function of the market's movement. In addition to risk (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 r
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