What is meant by tracking error due to systematic risk factors?

Question

What will be an ideal response?

Answer 1

By tracking error due to systematic risk factors, we mean tracking error caused by factors that affect the return of securities in the benchmark in varying degrees. More details are given below.

When a portfolio manager's benchmark is a bond market index, risk is not measured in terms of the standard deviation of the portfolio's return. Instead, risk is measured by the standard deviation of the return of the portfolio relative to the return of the benchmark index. This risk measure is called tracking error. Tracking error is also called active risk.

Forward-looking tracking error indicates the degree of active portfolio management being pursued by a manager. Therefore, it is necessary to understand what factors (including systematic risk factors) affect the performance of a manager's benchmark index. The degree to which the manager constructs a portfolio that has exposure to the risk factors that is different from the risk factors that affect the benchmark determines the forward-looking tracking error.

The risk factors affecting the Lehman Brothers Aggregate Bond Index have been investigated by various researchers. The risk factors can be classified into two types: systematic risk factors and nonsystematic risk factors. Systematic risk factors are forces that affect all securities in
a certain category in the benchmark index. Nonsystematic factor risk is the risk that is not attributable to the systematic risk factors.

When we speak of tracking error due to systematic risk factors, we have two factors in mind because systematic risk factors can be divided into two categories: term structure risk factors and non-term structure risk factors. Term structure risk factors are risks associated with changes in the shape of the term structure (level and shape changes). Non-term structure risk factors include the following: sector risk, quality risk, optionality risk, coupon risk, MBS sector risk, MBS volatility risk, and MBS prepayment risk.