This is a question in CFAI Equity item sets.
My question is regarding the correct answer, as Manager B supposed to have lower excess return due to high tracking error!
Why was it considered luck not a skill, is it because Manager B’s holding number indicates that he is an active manager. So in that case he should have low excess return and low tracking error?
Manager A** Manager B **Manager C Benchmark S&P 500 MSCI EAFE Russell 3000 Number of holdings: Fund/index 498/500 800/928 1,200/3,000 Usage of futures For cash drag For currency overlay No Accounts for covariances No No Yes Tracking error 0.06% 1.97% 0.34% Excess return 0.10% 2.10% –0.15%
In reviewing the relative performance of Manager B from Exhibit 1, Parker makes the following statements:
- He faced more volatile markets than the others did, based on the tracking errors.
- He used currency overlays to lever the returns of securities held in foreign currency.
- His excess return looks like it is more a matter of luck than skill.
Q. Which of Parker’s statements about Manager B in Exhibit 1 is most appropriate? The statement about:
- tracking errors.
- excess return.
- currency overlays.
B is correct. The comment about excess return being luck rather than skill is correct. Replication managers attempt to create a portfolio that tracks the performance and the volatility of the underlying index as closely as possible. The proper measure of skill is the tracking error: Manager B has the highest tracking error among the three managers.