Tracking Error Definition, Factors That Affect It, Example

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Understanding Tracking Error in Finance

When it comes to managing your investments, it’s essential to have a deep understanding of various financial metrics. One such metric is tracking error, which plays a crucial role in evaluating the performance of investment portfolios or funds. In this blog post, we’ll explore the definition of tracking error, the factors that affect it, and provide an example to help you grasp its significance.

What is Tracking Error?

Tracking error is a financial metric that determines the volatility of returns between a portfolio or fund and its benchmark. It measures the extent to which the portfolio’s performance deviates from that of the benchmark. Put simply, tracking error indicates how closely an investment portfolio follows its intended benchmark index.

Factors That Affect Tracking Error:

Several factors can contribute to tracking error:

1. Transaction Costs: Costs incurred during buying and selling securities within the portfolio can impact tracking error. Higher transaction costs can reduce the portfolio’s returns, consequently increasing the tracking error.
2. Management Fees: The fees charged by fund managers to manage the portfolio can affect tracking error. Higher management fees can erode the portfolio’s returns, leading to a higher tracking error.
3. Asset Allocation: The mix of different asset classes within the portfolio compared to the benchmark can impact tracking error. If the portfolio has a significantly different asset allocation compared to its benchmark, it may result in a higher tracking error.
4. Security Selection: Individual security choices made within the portfolio can influence tracking error. If the portfolio holds securities different from the benchmark, it may result in a higher tracking error.

An Example:

Let’s understand tracking error with an example:

Suppose you have a portfolio that aims to track the performance of the S&P 500 index, which is your benchmark. Over a specific period, your portfolio returns 8%, while the S&P 500 index returns 10%. In this scenario:

• Your portfolio’s tracking error would be 2%, as it deviates by 2% from the benchmark.
• A higher tracking error indicates that the portfolio’s performance is less correlated with the benchmark.
• A lower tracking error indicates a closer alignment between the portfolio and the benchmark.

It’s important to note that tracking error alone may not provide a complete picture of the portfolio’s performance. It should be considered alongside other metrics and factors to evaluate the overall investment strategy.

As an investor, understanding tracking error can help you assess the effectiveness of your investment portfolio or fund. By paying attention to factors that affect tracking error, you can make informed decisions to optimize your investment strategy.

So, the next time you come across the term tracking error, you’ll have a clear understanding of what it entails and its significance in the world of finance.