![]() ![]() The latter way to compute the tracking error complements the formulas below but results can vary (sometimes by a factor of 2). In a factor model of a portfolio, the non-systematic risk (i.e., the standard deviation of the residuals) is called "tracking error" in the investment field. Various types of ex-ante tracking error models exist, from simple equity models which use beta as a primary determinant to more complicated multi-factor fixed income models. ![]() Ex-post tracking error is more useful for reporting performance, whereas ex-ante tracking error is generally used by portfolio managers to control risk. The aim is to find the best practice available to get the job done with minimum effort or resources. If a model is used to predict tracking error, it is called 'ex ante' tracking error. Definition: Internal benchmarking is a process in which a company or an organisation looks within its own business to try and determine the best practice or methodology for conducting a particular task. If tracking error is measured historically, it is called 'realized' or 'ex post' tracking error. In addition to risk (return) from specific stock selection or industry and factor "betas", it can also include risk (return) from market timing decisions.ĭividing portfolio active return by portfolio tracking error gives the information ratio, which is a risk adjusted performance measure. Thus the tracking error does not include any risk (return) that is merely a function of the market's movement. Tracking error is a measure of the deviation from the benchmark the aforementioned index fund would have a tracking error close to zero, while an actively managed portfolio would normally have a higher tracking error. Some portfolios are expected to replicate, before trading and other costs, the returns of an index exactly (e.g., an index fund), while others are expected to ' actively manage' the portfolio by deviating slightly from the index in order to generate active returns. Many portfolios are managed to a benchmark, typically an index. The best measure is the standard deviation of the difference between the portfolio and index returns. In finance, tracking error or active risk is a measure of the risk in an investment portfolio that is due to active management decisions made by the portfolio manager it indicates how closely a portfolio follows the index to which it is benchmarked. ![]()
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