Why might one expect that for a manager pursuing an active management strategy that the backward-looking tracking error at the beginning of the year will deviate from the forward-looking tracking error at the beginning of the year?
What will be an ideal response?
The portfolio manager needs a forward-looking estimate of tracking error to reflect the portfolio risk going forward. The way this is done in practice is by using the services of a commercial vendor or dealer firm that has modeled the factors that affect the tracking error associated with the bond market index that is the portfolio manager's benchmark. Given a manager's current portfolio holdings, the portfolio's current exposure to the various risk factors can be calculated and compared to the benchmark's exposures to the factors. Using the differential factor exposures and the risks of the factors, a forward-looking tracking error for the portfolio can be computed. Given a forward-looking tracking error, a range for the future possible portfolio active return can be calculated assuming that the active returns are normally distributed.
There is no guarantee that the forward-looking tracking error at the start of, say, a year would exactly match the backward-looking tracking error calculated at the end of the year. There are two reasons for this. The first is that as the year progresses and changes are made to the portfolio, the forward-looking tracking error estimate would change to reflect the new exposures. The second is that the accuracy of the forward-looking tracking error at the beginning of the year depends on the extent of the stability in the variances and correlations that commercial vendors use in their statistical models to estimate forward-looking tracking error.
These problems notwithstanding, the average of forward-looking tracking error estimates obtained at different times during the year can be reasonably close to the backward looking tracking error estimate obtained at the end of the year. The forward-looking tracking error is useful in risk control and portfolio construction. The manager can immediately see the likely effect on tracking error of any intended change in the portfolio. Thus scenario analysis can be performed by a portfolio manager to assess proposed portfolio strategies and eliminate those that would result in tracking error beyond a specified tolerance for risk.
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