The error of tracking error

Craig L Israelsen () and Gary F Cogswell
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Craig L Israelsen: 2055 JFSB, Brigham Young University

Journal of Asset Management, 2007, vol. 7, issue 6, No 6, 419-424

Abstract: 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.

Keywords: tracking error; alpha; information ratio; ‘benchmark differential’ (search for similar items in EconPapers)
Date: 2007
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DOI: 10.1057/palgrave.jam.2250051

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