For a question from Qbank (#92383), it says that the higher trading cost (of rebalancing consistently to maintain an asset class target portfolio weight vs rebalancing to within an allowed range) could increase the tracking error of the portfolio versus one that has allowable tradin bands. I don’t get it and could someone please clarify? Thanks
if you rebalance each time your weights are different from the benchmark - your trading costs would be higher - which would increase tracking risk (since the cost is not incurred on the benchmark, but is on your portfolio).
with a trading band - you would rebalance ONLY if you went outside the band - so fewer rebalances. (your bands would be based on the various factors - riskiness of the asset class etc, correlation with other asset classes in hte portfolio). fewer rebalances = lower transaction costs = lower tracking risk wrt benchmark.
Hi cpk123, thanks for your clarification. How does the trading cost relate to tracking risk? I don’t understand how these 2 are related. Thanks.
tracking risk = std deviation (return on portfolio - return on benchmark)
return on portfolio - is now lower because of the trading costs.
no such adjustment to return on benchmark.
so when more trading costs - higher tracking risk.
Got it! Thanks for the crystal clear explanation!!