If you look up “tracking error” on wikipedia, it says “It measures the standard deviation of the difference between the portfolio and index returns. In the curriculum, “tracking error” is also known as “active return” and is defined as the difference between the return on the portfolio vs the benchmark. There is no standard deviation mentioned in this definition.
On the other hand, if you look up “tracking risk” in wikipedia, it doesn’t give anything, but if you look up “active risk”, which according to CFA is another workd for “tracking risk”, it says it “is defined as the annualized standard deviation of the monthly difference between portfolio return and benchmark return.
In the curriculum, “tracking risk” is defined as the standard deviation of the active return. It is broken into 2 parts, active factor risk (such as over or under weighting industries) and active specific risk (such as specific stocks).
My question is, wouldn’t portfolio managers consider minimizing specific components of tracking risk and not tracking error? I could understand that a PM may not want to bet too heavily on a few industries so that the benchmark is no longer applicable. I do not understand why they’d want to reduce the tracking error (active return), which is the difference between their returns and the index. After all, isn’t that what they’re getting paid to do?
The reason I’m asking is because I’ve come across 2 cases while reading about the portfolio mangers strategies where they’ve said they want to keep “tracking error” below a certain %.
On the other hand, if you look up “tracking risk” in wikipedia, it doesn’t give anything, but if you look up “active risk”, which according to CFA is another workd for “tracking risk”, it says it “is defined as the annualized standard deviation of the monthly difference between portfolio return and benchmark return.
In the curriculum, “tracking risk” is defined as the standard deviation of the active return. It is broken into 2 parts, active factor risk (such as over or under weighting industries) and active specific risk (such as specific stocks).
My question is, wouldn’t portfolio managers consider minimizing specific components of tracking risk and not tracking error? I could understand that a PM may not want to bet too heavily on a few industries so that the benchmark is no longer applicable. I do not understand why they’d want to reduce the tracking error (active return), which is the difference between their returns and the index. After all, isn’t that what they’re getting paid to do?
The reason I’m asking is because I’ve come across 2 cases while reading about the portfolio mangers strategies where they’ve said they want to keep “tracking error” below a certain %.