The error of tracking error

Abstract

As the application of modern portfolio theory has evolved within an equities market increasingly focused on passively managed portfolios, tracking error (ie performance variance from a benchmark index) has emerged as a primary measure for evaluating the performance of managers, where low tracking error is typically viewed as a positive in terms of risk management. Ironically, actively managed mutual funds with low tracking error exhibit lower alpha, higher beta, and lower average performance compared to funds with high tracking error. Ranking funds using the information ratio incorporates tracking error as the denominator (IR=alpha/tracking error). High IR funds demonstrate lower volatility of return, higher alpha, lower beta, and higher returns than funds with low IR. As additional irony, high IR funds demonstrate significantly higher tracking error than low IR funds.Journal of Asset Management (2007) 7, 419–424. doi:10.1057/palgrave.jam.2250051 [ABSTRACT FROM AUTHOR] Copyright of Journal of Asset Management is the property of Palgrave Macmillan Ltd. and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use. This abstract may be abridged. No warranty is given about the accuracy of the copy. Users should refer to the original published version of the material for the full abstract. (Copyright applies to all Abstracts.)