Tracking error is a concept that all investors and financial professionals need to understand. It measures how closely an investment follows the performance of its intended benchmark or index, and it can be a valuable tool for measuring portfolio performance. Let’s take a closer look at tracking error and how it works.
What is Tracking Error?
Tracking error is the difference between an investment’s actual return and the expected return of its benchmark or index. This number helps investors measure how well their investments are performing relative to their desired benchmark. The higher the tracking error, the more variance there is between the two numbers, suggesting that the portfolio is not performing as well as it should be given its assigned benchmark or index. Conversely, a low tracking error indicates that the portfolio is almost perfectly in line with its intended benchmark.
Calculating Tracking Error
Calculating tracking error isn’t overly complex; you simply subtract the expected return from your actual return, divide by your expected return, then multiply by 100 (to get a percentage). To make sure you’re getting an accurate picture of your investments’ performance, calculate your tracking error for both short-term (monthly) and long-term (annual) periods. This will help you determine if any discrepancies are due to changes in market conditions or if they’re indicative of larger problems with your portfolio management strategy.
Using Tracking Error to Improve Portfolio Performance
Once you’ve calculated your tracking error, use this information to refine your portfolio management strategy so that it more effectively meets its objectives. For example, if during times of market volatility your tracking errors are higher than usual, adjust your risk tolerance levels so that you’re more likely to meet your goals even when markets get turbulent. Additionally, make sure that you’re regularly monitoring your investments for any other potential factors (such as fees) that could be causing increased variance from your desired benchmarks or indexes.
Overall, understanding and calculating tracking error can be helpful in gauging portfolio performance over time and optimizing portfolios so they more accurately meet their intended goals. For investors and financial professionals alike, calculating this metric on a regular basis can help ensure that portfolios remain on track towards achieving their ultimate objectives regardless of market conditions or other external factors. By being diligent about monitoring this metric over time investors can ensure that their portfolios remain in line with their intended strategies while also helping them reduce risk exposure during volatile market periods.