theres a question in the mock exam which asks According to the data in Exhibit 2, which portfolio most likely exhibits the risk characteristics of an aggressive active equity manager?
Pacific Rim portfolio
the answer is 1. pacific rim has the highest tracking error whereas my answer was japan portfolio b.c it had the highest information ration. i assumed that if you are measuring which pm is the most aggressive you would be looking at a returns that is adjusted for volatility i.e. information ratio.
the tracking error just measures the volatility in the market whereas ir actually normalizes your returns after taking into account therefore the pm with the highest ir must be skilled enough/aggressive enough to achieve a high returns after adjusting for volatility. why is this not correct?
Tracking error measures how differently your portfolio performed relative to the benchmark. Higher tracking error means the portfolio is not following (tracking) the benchmark returns. Eg - a closet index fund is said to have a very low active risk and pretty much follows the benchmark (the reason for ots Sharpe ratio being = benchmarks Sharpe ratio). This fund would have a lower tracking error.
Exactly. Think about it another way. All else equal, if you want to be aggressive, what do you do: (1) take on more risk, (2) take on same risk, or (3) take on less risk? The obvious answer is (1) take on more risk. So if you’re being more aggressive and taking on more risk, all else equal, you will have higher active risk. The information ratio takes it a step further and tells you how the portfolio manager is performing relative to the risk they are taking on, similar to the Sharpe Ratio.
Actually, this isn’t right. The tracking error tells us what saurabh03121992 just said…
Tracking error is a measure of the deviation from the benchmark and not a measure of risk in itself; the aforementioned index fund would have a tracking error close to zero, while an actively managed portfolio would normally have a higher tracking error. The more deviation away from the benchmark, the more aggressive that manager is according to the IR…
Sharp ratio would be divided by the standard derivation aka risk, which is what you’re more so described.