Investment managers spend a lot of time thinking about portfolio risk – usually in terms of volatility and drawdowns. Tracking error is an often underdiscussed source of risk that portfolio managers, financial advisors, and clients should take seriously.
What is tracking error?
For any portfolio that is different than its benchmark, tracking error is an important source of risk to consider. Tracking error is calculated as the volatility of portfolio returns relative to the benchmark returns – also known as excess returns.
To illustrate what tracking error looks like, consider the excess monthly returns of hypothetical Funds A and B. Though both have an average monthly excess return of ~.3%, the returns of each fund are very different. Visually, you can tell that Fund B consistently deviates from the benchmark to a greater degree than fund A. This is what it means to have higher tracking error. We can infer that the manager of Fund A is making relatively smaller active bets away from the benchmark, while the manager of fund B is making relatively larger bets away from the benchmark. In the hypothetical scenario below, Fund A has a higher “information ratio” (alpha or outperformance per unit of tracking error), since excess return is the same on a much smaller tracking error.
Tracking error on its own is neither good nor bad. It measures both periods of outperformance and underperformance relative the benchmark and does not distinguish between the two. An investor would prefer high tracking error if there was a high degree of outperformance but a low tracking error if there was consistent underperformance.
Why does tracking error matter?
Financial advisors need to be aware of their clients’ tolerance for tracking error and manage portfolios accordingly. If the tracking error of the portfolio exceeds client tolerance, the risk that the client will not stick with the strategy during tough times rises – much like if the volatility profile of a strategy exceeds the client’s tolerance for volatility. Because of this, advisors should have conversations with clients and set expectations, especially if pursuing strategies with high tracking error.
Even the greatest investment strategies will yield poor results if clients abandon ship at the wrong time. Alpha Architect wrote an excellent blog post called “Even God Would Get Fired as an Active Manager.” If you are familiar with quantitative finance and want to get the full details, please check out the post on their website The basic premise is: if you knew ahead of time the stocks with the both the best and worst 5-year returns, went long the best stocks and short the worst stocks, you would (obviously) have excellent returns, but there would be subperiods of substantial underperformance relative to a benchmark (tracking error) that would likely get you fired as an investment manager today. The moral of the story – when managing money for others, tracking error matters and must be taken seriously.
The Bottom Line
Tracking error is an important source of risk that does not always get the attention it deserves. Client portfolios should be managed in a way that is consistent with their tolerance and expectation. At Invariant, our investment process for portfolios begins with a cap-weighted benchmark portfolio. From there, we make modifications based on our active views, limiting tracking error risk to when we believe that it is worth it.