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 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 I could understand that a PM may not want to bet too heavily on a few industries so that the benchmark is no longer applicable.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 certain %.
tracking error is the standard deviation of the difference between the portfolio return and the benchmark. the confusion lies in who is defining it. i have no idea why schweser defines it this way you should probably forget about defining “portfolio return - benchmark return” as tracking error > I do not understand why they’d want to reduce the tracking error (active return) make sense now?
FOr the investors, who were told by the fund/portfolio manager that they track say S&P500. If you invest in that fund because you are confident they are large caps, highly liquid, good companies with good corp. governance etc. Obviously you would not like the fund manager to deviate from your mandate and invests in small/mid-cap stocks. There is a risk in this type of style drift. That is why the Fund manager might say my tracking error is say 5%. based on this info you are sure 95% your funds will be invested in S&P500 and rest are outside S&P. Here reducing tracking error means, investing closely as per the mandate. Higher tracking error means deviating from the pre-defined mandate of invesments (style drift) Hope this helps.
lol my explanation is cut out for some reason
Wouldn’t adherence to the types of securities in a particular index be better measured by the R^2, where if its less than 70% you know its not an appropriate benchmark? I understand the idea that you want a fund manager to invest with a particular style, but isn’t that part of tracking risk (active factor risk) and not the overall tracking error? FRM2cfa Wrote: ------------------------------------------------------- > FOr the investors, who were told by the > fund/portfolio manager that they track say S&P500. > If you invest in that fund because you are > confident they are large caps, highly liquid, good > companies with good corp. governance etc. > Obviously you would not like the fund manager to > deviate from your mandate and invests in > small/mid-cap stocks. There is a risk in this > type of style drift. > > That is why the Fund manager might say my tracking > error is say 5%. based on this info you are sure > 95% your funds will be invested in S&P500 and rest > are outside S&P. > > Here reducing tracking error means, investing > closely as per the mandate. Higher tracking error > means deviating from the pre-defined mandate of > invesments (style drift) > > Hope this helps.
Anyone know the answer to this?
yes, it’s correct to say that a style-drift could be totally incorporated by the Active Factor Risk component of the Active Risk Squared Active Risk Squared = Variance of Tracking Error = Active ‘Factor Risk’ + Active ‘Specific Risk’ So if the fund manager has exact same risk exposure factors as the index which it is tracking then Active Factor Risk is approx 0, which goes to say that the manager exactly follows the sentiments of the index it tracks.
I’m looking at my notes, and I see tracking error (active return) as the return on portfolio minus return on benchmark. Tracking risk (active risk) is the standard deviation of tracking error (active return). Factor risk and specific risk are different. Active Factor risk concerns with deviations in portfolio factor sensitivities to the benchmark. Active Specific risk concerns with deviations in asset weightings compared to the benchmark.
Your notes have summed it up pretty well, Niblita. That is what is the crux of Active Risk/Return LOS.