What is tracking error?
What will be an ideal response?
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.
Tracking error is computed as follows. First, compute the total return for a portfolio for each period. Second, obtain the total return for the benchmark index for each period. Third, obtain the difference between the return values for portfolio and index for each period. The difference for each period is referred to as the active return for that period. Finally, compute the standard deviation of the active returns. The resulting value is the tracking error.
One should not that the tracking error measurement is in terms of the observation period. If monthly returns are used, the tracking error is a monthly tracking error. If weekly returns are used, the tracking error is a weekly tracking error. Tracking error is annualized as follows. When observations are monthly: annual tracking error= monthly tracking error × . When observations are weekly: annual tracking error = monthly tracking error × .
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