Why is the tracking error more important than portfolio variance of returns when a portfolio manager's performance is measured versus a benchmark?

Question

What will be an ideal response?

Answer 1

A key point is that in constructing a portfolio where there is a benchmark, the relevant risk measure is not the portfolio variance but the portfolio tracking error. When performance is measured against a benchmark, tracking error is more important than portfolio variance because on tracking error measures how closely a portfolio follows the index to which it is benchmarked. The most common measure is the root-mean-square of the difference between the portfolio and index returns.

Many portfolios are managed to a benchmark, normally an index. Some portfolios are expected to replicate, before trading and other costs, the returns of an index exactly (an index fund), while others are expected to 'actively manage' the portfolio by deviating slightly from the index in order to generate active returns or to lower transaction costs. Tracking error (also called active risk) is a measure of the deviation from the benchmark; the aforementioned index fund would have a tracking error close to zero, while an actively managed portfolio would normally have a higher tracking error. Dividing portfolio active return by portfolio tracking error gives the information ratio, which is a risk adjusted performance metric.