What Is a Tracking Error?
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What Is a Tracking Error?

4 Min.

Tracking error refers to the difference between the actual performance of an investment portfolio and its benchmark. It can be used as an indicator of how actively a fund is managed and its risk level. By assessing the past tracking error of a portfolio manager, you can gain insight into their ability to control benchmark risk in the future.

Basics

In the financial realm, performance deviation signifies the variance in price movements between a position or portfolio and a benchmark. Typically associated with hedge funds, mutual funds, or exchange-traded funds (ETFs), instances arise where the anticipated effectiveness falls short, resulting in unforeseen gains or losses. Expressed as a standard deviation percentage difference, tracking error quantifies the disparity between an investor's return and the benchmark they sought to replicate.

Tracking Error Explained

Tracking error is a vital metric in evaluating investment performance against a benchmark, offering insights into the portfolio's consistency over a defined timeframe. Even when portfolios align closely with benchmarks, subtle day-to-day, quarter-to-quarter, or year-to-year variations exist. This discrepancy is quantified by tracking error, which is calculated as the standard deviation of the difference between investment and benchmark returns.

The formula for tracking error is expressed as:

Tracking Error = Standard Deviation of (P - B)

Where: 

  • P is portfolio return;
  • B is benchmark return.

Investors employ tracking error to scrutinize portfolio managers; a manager exhibiting low average returns coupled with a substantial tracking error signals underlying issues, prompting investors to consider alternative options.

Beyond retrospective analysis, tracking error aids in performance prediction, particularly for quantitative portfolio managers. These managers utilize risk models encompassing key influencing factors on price changes. By aligning portfolio constituents with benchmark attributes such as style, leverage, momentum, or market cap, managers aim to construct portfolios with minimal tracking error, enhancing the likelihood of adherence to benchmark performance.

Factors Influencing Tracking Error in Investment Instruments

Factors impacting tracking error in investment instruments are multifaceted and encompass various aspects of fund management. One determinant is the net asset value (NAV) of an index fund, inherently lower than its benchmark due to fund fees. A high expense ratio can adversely affect fund performance, yet adept portfolio management, including rebalancing and effective handling of dividends or interest payments, can mitigate this impact.

Additionally, the composition of a fund's holdings vis-à-vis the underlying index significantly influences tracking error. Variances in weighting and the presence of illiquid or thinly-traded securities can amplify tracking error, as price differentials during transactions contribute to deviations from market prices.

Premiums or discounts to Net Asset Value can arise when market prices deviate from the NAV of an ETF's securities basket. Such discrepancies, although infrequent, prompt arbitrage actions by authorized participants, helping restore equilibrium. Furthermore, portfolio optimization is employed when thinly traded stocks in the benchmark index hinder direct purchases, leading to the use of more liquid stocks as proxies.

Diversification constraints mandated by regulators impose limitations on ETFs, stipulating that 75% of assets must be invested in specified categories and restricting exposure to any single security to no more than 5% of total assets. This poses challenges for ETFs tracking sectors dominated by a few key companies.

Cash drag, a decline in performance due to cash accumulation from dividends, overnight balances, and trading activity, affects dividend funds with high payout yields. Index changes, capital-gains distributions resulting from high turnover rates, securities lending, currency hedging costs, and futures roll in commodity ETFs are additional factors contributing to tracking error.

Leveraged and inverse ETFs face unique challenges, requiring daily rebalancing of derivatives to maintain constant leverage. Understanding and managing these diverse factors is crucial for investors navigating the complexities of tracking error in the realm of investment instruments.

Tracking Error Example 

Consider a scenario involving a large-cap mutual fund benchmarked against the S&P 500 index over five years. The respective annual returns for the mutual fund and the index are as follows:

  • Mutual Fund: 11%, 3%, 12%, 14%, 8%
  • S&P 500 index: 12%, 5%, 13%, 9%, 7%

To calculate the tracking error, the differences between corresponding returns are computed: (11% - 12%), (3% - 5%), (12% - 13%), (14% - 9%), and (8% - 7%), resulting in -1%, -2%, -1%, 5%, and 1%, respectively. The standard deviation of these differences, representing the tracking error, is determined to be 2.50%.

Conclusion

Tracking error serves as a crucial measure for evaluating the alignment of an investment portfolio with its benchmark, offering valuable insights into its historical consistency. This metric not only aids in understanding a fund's active management and risk profile but also provides a basis for predicting future performance. By scrutinizing the tracking error alongside other influencing factors, investors can make informed decisions about portfolio managers and navigate the intricacies of investment instruments, ultimately enhancing their ability to achieve desired outcomes in the dynamic financial landscape.

Tracking Error
Exchange-Traded Funds (ETFs)
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