Within the field of investment management, tracking error is a commonly used metric to assess how well investment portfolios are performing. It gauges how closely the returns in a portfolio resemble those of a benchmark index. Investors must comprehend tracking error since it offers important information about the performance and risk of their investments.
Key Takeaways
- Tracking error is a measure of how closely an investment portfolio follows its benchmark index.
- Negative tracking error occurs when a portfolio outperforms its benchmark index.
- Negative tracking error can provide diversification benefits and potentially higher returns for investors.
- There is a positive correlation between tracking error and investment performance, but it is not a guarantee of outperformance.
- Active management plays a crucial role in generating negative tracking error, but it also carries higher risks for investors.
The standard deviation of the difference between a portfolio’s returns and those of a benchmark index is known as tracking error. It calculates how far a portfolio strays from its benchmark. If the tracking error is low, it means that the portfolio closely follows the benchmark; if it is high, it means that the returns of the portfolio deviate significantly from the benchmark. Comparing the portfolio’s returns over a given time period to the benchmark’s returns is how tracking error is calculated. The standard deviation of this difference is then computed by taking the difference between the two sets of returns.
We can use this standard deviation to calculate the tracking error. Because it sheds light on how well a portfolio manager can mimic the performance of a benchmark, tracking error is a crucial metric for assessing investment performance. A portfolio manager may be taking on excessive risk or departing from the benchmark in a way that may not be advantageous to investors if the tracking error is high. Conversely, a low tracking error indicates that the manager is successfully managing the portfolio to closely match the benchmark. A situation where the returns of a portfolio are less than the returns of the benchmark is known as negative tracking error.
The fact that negative tracking error does not always imply subpar performance is important to remember. That merely indicates that the returns in the portfolio are less than those in the benchmark. Negative tracking error is caused by a number of factors. Having fees and costs related to portfolio management is one common reason. A negative tracking error may arise from these expenses, which reduce the portfolio’s returns.
Decisions made by the portfolio manager regarding investments can also result in negative tracking error. The manager may experience lower returns and a negative tracking error if they take on positions that differ significantly from the benchmark. This could happen if the manager uses a different approach to investing or thinks that a particular stock will perform better than the benchmark. Even though negative tracking error might first appear to be a bad thing, there are some circumstances in which it can really be advantageous to investors.
A portfolio manager who actively manages the portfolio and makes investment decisions that diverge from the benchmark may be indicated by a negative tracking error. Investors may see outperformance and increased returns as a result of this proactive management. On the other hand, when the returns of the portfolio exceed the returns of the benchmark, positive tracking error happens. Positive tracking error may seem good, but it can also mean that the portfolio manager is overly risk-taking or making speculative investments that might not hold up over time.
The degree of risk attached to the portfolio should be taken into account when assessing tracking error. For investors who are more risk averse, a portfolio with a higher tracking error and higher risk may be more appropriate than one with a lower tracking error and lower risk. An important factor in assessing the performance of investments is tracking error.
It offers information about how successfully a portfolio manager can control risk and match the performance of a benchmark. It is crucial to remember that tracking error is only one of several performance indicators to take into account when assessing the success of an investment. Other performance measures, like beta and alpha, provide more details about the risk-adjusted returns & market sensitivity of a portfolio. Whereas alpha gauges the excess return produced by the portfolio manager, beta assesses how sensitive the portfolio is to changes in the market, and tracking error concentrates on the deviation from the benchmark.
Tracking error should be taken into account along with other performance metrics when assessing the success of investments. A portfolio that closely tracks the benchmark and has a low tracking error and positive alpha could suggest that the portfolio manager can produce excess returns. A portfolio with a high tracking error and negative alpha, on the other hand, can indicate that the manager is taking on too much risk without producing appreciable excess returns. Portfolio managers may be able to take advantage of investment opportunities that are not present in the benchmark due to negative tracking error, which could help investors outperform the market.
Portfolio managers can actively manage the portfolio and make investment decisions with the potential to yield higher returns by departing from the benchmark. Portfolio managers, for instance, might think that specific industries or sectors will perform better than the market as a whole. The manager may be able to outperform the benchmark by overweighting these industries or sectors in the portfolio. Since the returns of the portfolio may differ from the benchmark, this active management approach may cause a negative tracking error.
Negative tracking error has been used in some profitable investment strategies to outperform the market. By taking long positions in stocks they think will appreciate in value and short positions in stocks they think will decline in value, for instance, some hedge funds use long-short strategies. With a negative tracking error, this strategy enables them to produce returns that are not exclusively reliant on the performance of the market as a whole.
When creating negative tracking error, active management is essential. In an effort to produce larger returns, active managers actively choose their investments and diverge from the benchmark. Since the returns of the portfolio may differ from the benchmark, this active management may cause a negative tracking error. By contrast, tracking error is minimized and benchmark performance is emulated with passive management.
Investing in index funds or exchange-traded funds (ETFs) that closely mirror a particular benchmark is the norm for passive managers. Passive management may limit the opportunity for outperformance even though it may also reduce tracking error. The investment style of the portfolio manager should be taken into account when assessing tracking error. There may be variations in tracking error depending on the type of investment, such as growth or value investing.
The investor’s objectives & risk tolerance should be taken into consideration when choosing an investment style. Investors may profit from negative tracking error, but there are risks to be mindful of. A negative tracking error may be a sign that the portfolio manager is overly risk-taking or departing from the benchmark in a way that might not be advantageous to investors.
Investors can utilize various strategies to reduce the potential risks associated with negative tracking error. Among these strategies is diversification. Investors can lessen the impact of specific securities or sectors on the performance of the entire portfolio by diversifying the portfolio across a variety of asset classes, industries, and geographic locations.
This can lessen the chance of notable departures from the benchmark and help control tracking error. Giving asset allocation careful thought is another tactic. Investors can potentially lower tracking error and manage risk by distributing their assets among various asset classes, such as cash, bonds, and stocks. The investor’s time horizon, risk tolerance, and goals should all be taken into consideration when allocating assets.
In order to control tracking error, diversification is essential. Investors can lessen the impact of specific securities or sectors on the performance of the entire portfolio by diversifying the portfolio across a variety of asset classes, industries, and geographic locations. By doing so, the possibility of notable departures from the benchmark can be minimized & tracking error can be managed. The performance of a single security or sector is less likely to have an impact on a diversified portfolio. The effect on the entire portfolio will be negligible if one security or industry underperforms.
As a result, tracking error may be decreased and investment performance may be more stable. On the other hand, substantial departures from the benchmark are more likely to occur in a concentrated portfolio that is heavily weighted towards a small number of stocks or sectors. A concentrated position’s underperformance can have a big effect on the performance of the entire portfolio and raise the tracking error. It is possible to assess & ascertain the efficacy of investment strategies by tracking error. Investors can evaluate how closely and effectively various investment strategies track their respective benchmarks by comparing the tracking errors of those strategies. It’s crucial to take other performance metrics into account when assessing investment strategies based on tracking error.
Tracking error should be considered in conjunction with metrics such as alpha, beta, & Sharpe ratio to get a comprehensive view of the strategy’s performance and risk-adjusted returns. Examining investment strategies also requires taking diversification and risk into account. For conservative investors, a strategy with a low tracking error & low risk may be more appropriate, whereas a strategy with a higher tracking error and higher risk may be better suited for investors with a higher risk tolerance. Ultimately, tracking error is a crucial investment management metric that sheds light on the risk and performance of investment portfolios.
Although negative tracking error might appear to be a bad thing at first, it can really help investors since it gives portfolio managers more freedom to actively manage the investment & possibly increase returns. Nonetheless, it’s critical to take into account the dangers of negative tracking error and to carefully assess investment strategies using a wide range of performance indicators. While assessing tracking error, individual investment goals and risk tolerance should also be taken into account.
Investors may match their portfolios to their personal risk tolerance and goals by having a better understanding of tracking error & its ramifications.
If you’re interested in learning more about investing and financial management, you might also find our article on “How to Take Vitamin D” intriguing. Just like tracking error can be negative, the lack of vitamin D in our bodies can have negative effects on our health. In this article, we explore the importance of vitamin D, its sources, and how to ensure you’re getting enough of it. Check it out here!
FAQs
What is tracking error?
Tracking error is a measure of how closely an investment portfolio follows the performance of its benchmark index.
Can tracking error be negative?
Yes, tracking error can be negative. A negative tracking error indicates that the portfolio has outperformed its benchmark index.
What does a negative tracking error mean?
A negative tracking error means that the portfolio has outperformed its benchmark index. This can be a good thing for investors as it indicates that the portfolio manager has made good investment decisions.
Is a negative tracking error always good?
Not necessarily. A negative tracking error can be good if it is the result of good investment decisions by the portfolio manager. However, it can also be the result of luck or taking on excessive risk.
What is a good tracking error?
A good tracking error is one that is low and consistent over time. A low tracking error indicates that the portfolio is closely following its benchmark index, while consistency indicates that the portfolio manager is making good investment decisions.
How is tracking error calculated?
Tracking error is calculated by subtracting the return of the benchmark index from the return of the portfolio, and then calculating the standard deviation of the difference.
