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The error of tracking error

Author

Listed:
  • Craig L Israelsen

    (2055 JFSB, Brigham Young University)

  • Gary F Cogswell

Abstract

As the application of modern portfolio theory has evolved within an equities market increasingly focused on passively managed portfolios, tracking error (ie performance variance from a benchmark index) has emerged as a primary measure for evaluating the performance of managers, where low tracking error is typically viewed as a positive in terms of risk management. Ironically, actively managed mutual funds with low tracking error exhibit lower alpha, higher beta, and lower average performance compared to funds with high tracking error. Ranking funds using the information ratio incorporates tracking error as the denominator (IR=alpha/tracking error). High IR funds demonstrate lower volatility of return, higher alpha, lower beta, and higher returns than funds with low IR. As additional irony, high IR funds demonstrate significantly higher tracking error than low IR funds.

Suggested Citation

  • Craig L Israelsen & Gary F Cogswell, 2007. "The error of tracking error," Journal of Asset Management, Palgrave Macmillan, vol. 7(6), pages 419-424, March.
    • Handle: RePEc:pal:assmgt:v:7:y:2007:i:6:d:10.1057_palgrave.jam.2250051
    DOI: 10.1057/palgrave.jam.2250051
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    Cited by:

    1. Stephen Lee & Giacomo Morri, 2015. "Real estate fund active management," Journal of Property Investment & Finance, Emerald Group Publishing Limited, vol. 33(6), pages 494-516, September.

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