Tracking Error Management

Tracking error and excess return are two measures that enable investors to differentiate performance among passive portfolio managers. Tracking error indicates how closely the portfolio behaves like its benchmark and measures a manager’s ability to replicate the benchmark return.

 Tracking error is calculated as the standard deviation of the difference between the portfolio return and its benchmark index return. Excess return measures the difference between the portfolio returns and benchmark returns.

 Differences between portfolio returns and index returns are caused by:

  • Management fees.
  • Commissions on trades.
  • Sampling—compared to full replication, sampling typically increases tracking error.
  • Intraday trading, because index returns are based on closing prices.
  • Cash drag—index funds may hold cash balances that reduce returns in rising markets and increase returns in falling markets, as cash returns differ from index returns.

The process of controlling tracking error involves trade-offs between the benefits and costs of maintaining complete faithfulness to the benchmark index.

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