Equity Portfolio Tracking Error

Raman Vardharaj
Quantitative Portfolio Manager
Guardian Life Insurance
This presentation is based on the following unpublished paper: Determinants of tracking error for equity portfolios by Raman
Vardharaj, Frank Jones and Frank Fabozzi.
 How do you measure the risk of a stock portfolio?

Absolute risk: Volatility of returns

Relative risk: Volatility relative to a benchmark
Example: Tracking error or Active risk
 Definition of Tracking Error

Active return = Portfolio return - Benchmark return

Tracking error = standard deviation of active returns

Application: Information ratio = alpha / tracking error
(Alpha = average active return)

Estimation of tracking error:

- Trailing active returns (backward looking estimate)
- Risk model e.g., Barra (forward looking estimate)
 A Measure of Risk

An important risk metric for portfolios that are

managed versus a benchmark
Typical values:
- 0% for index funds
- less than 2% for enhanced index funds
- 5% for active large cap stock funds
 Tracking Error: An Example

Cumulative Tracking Error = 4%

Return

Rtn(BM) +4%
Benchmark
1 Std Dev
Cumulative
Rtn(Benchmark) or
Return 66% confident
Rtn(BM) -4%

Today Time

One year
from now
 Tracking Error: An Example

Tracking Error = 1%
Cumulative
Return

Benchmark Rtn(BM) +1% 1 Std Dev

Cumulative
Rtn(Benchmark) or
Return 66% confident
Rtn(BM) -1%

Today Time

One year
from now
 Determinants of tracking error

Number of stocks held - those in the benchmark and

those not in the benchmark
Size or Style or Sector bets
Beta
Benchmark volatility
 Effect of number of stocks

Tracking error falls as the portfolio includes more and

more of the stocks in the benchmark
An optimally constructed portfolio of just 50 stocks
can track the S&P 500 within 2%
Tracking error rises as the portfolio starts to include
stocks that are not in the benchmark
Tracking Error is Reduced as More Benchmark Stocks are Included

Tracking Error vs. the Number of Benchmark Stocks in the Portfolio

14%

12%
Large Cap

10%
Benchm ark: S&P 500
Tracking Error

8%

6%

4%

2%

0%
0 50 100 150 200 250 300 350 400 450 500
number of benchmark (S&P 500) stocks in the portfolio
Tracking Error Reduction Requires More Benchmark Stocks for
Mid Cap than for Large Cap

Tracking Error vs. the Number of Benchmark Stocks in the Portfolio

6%
Mid Cap
5%
Benchm ark: S&P 400
4%
Tracking Error

3%

2%

1%

0%
0 50 100 150 200 250 300 350 400
number of benchmark (S&P 400) stocks in the portfolio
Tracking Error Reduction Requires More Benchmark Stocks for
Small Cap than for Mid Cap

Tracking Error vs. the Number of Benchmark Stocks in the Portfolio

7%

6%
Small Cap
5%
Tracking Error

4% Benchmark: S&P 600

3%

2%

1%

0%
0 50 100 150 200 250 300 350 400 450 500 550 600
number of benchmark (S&P 600) stocks in the portfolio
Tracking Error Rises With the Increase in Non-Benchmark Stocks

Tracking Error vs. the Number of Non-Benchmark Stocks in the Portfolio

10%
Benchmark: S&P 100
9%
Tracking error

8%
Portfolio Universe: S&P 500

7%

6%

5%
100 150 200 250 300 350 400
number of non-benchmark (S&P 100) stocks in the portfolio

Note: All of the S&P 100 stocks are present in the S&P 500. We start w ith a portfolio that has all 100 of the stocks in the S&P 100 index and
progressively add to it stocks that are not in the S&P 100 index but are in the S&P 500 index. The tracking error for such a portfolio versus the
S&P 100 index is show n above. So, for example, w hen the portfolio has 200 of the S&P 500 stocks in addition to the S&P 100 stocks (i.e., 300 in all)
then its tracking error, upon optimal choice, is 6% as show n above.
 Effect of size and style

Tracking error rises as the portfolio deviates from its

benchmark in terms of average market cap (size) or
investment valuation (style)
Different portfolios can have the same tracking error
Effect of Size and Style Deviations on Tracking Error
Value Blend Growth

1
2 4
5 7
Large
3
1

8, 88

Mid
66

33

11
Small
55 77
22 44

Investment valuation is along the horizontal axis and market cap (size) is along the vertical axis.

Large Cap
Portfolio 1 has a tracking error of 0%. Portfolios 2, 3, 4 have nearly similar tracking errors of around 2.1%.
Portfolios 5, 6, 7 have nearly similar tracking errors of around 4.2%. Portfolio 8 has a tracking error of
8.5%. All of the above tracking errors are versus the S&P 500, the large cap index.

Small Cap
Portfolio 11 has a tracking error of 0%. Portfolios 22, 33, 44 have nearly similar tracking errors of around
1.7%. Portfolios 55, 66, 77 have nearly similar tracking errors of around 3.4%. Portfolio 88 has a tracking
error of 4.9%. All of these tracking errors are versus the S&P 600, the small cap index.
 Effect of sector bets and beta

Tracking error rises as the portfolios sector

allocations begin to differ from those of the
benchmark
Tracking error rises as the portfolios beta with
respect to the benchmark begins to differ from 1
Holding cash decreases a portfolios overall
volatility but increases its tracking error
 Tracking Error Increases as Sector Bets Increase

12%

10%

8%

6%

4%

2%

0%
12/31/99

12/31/00
3/31/99

6/30/99

9/30/99

3/31/00

6/30/00

9/30/00

3/31/01
Abs Sector bet RMS Sector bet Tkg Err

Using data pertaining to an actual mutual fund, this figure illustrates that the fund's tracking error with respect to the S&P 500 increased during
the calendar year 2000 as the fund placed increasingly larger sector bets. The tracking error values are predictive estimates from Barra.

We define sector deviation as the fund portfolio weight in a sector in excess of the benchmark weight in that sector. By definition, the sum of
all sector deviations as well as their average would be zero. We define the "Abs S ector Bet" as the average of the absolute values of the sector
deviations. The "RMS S ector Bet" is the root mean square sector deviation. That is, we first square the sector deviations, and calculate
their average. Then, we find the square root of this average. This is the RM S sector bet. The Abs Sector Bet and the RM S sector bet are two
indicators of the overall level of sector bets in the portfolio. Notice that the RM S sector bet measure appears to move more closely in line with
the Tracking Error than the Abs sector bet measure. Irrespective of which measure is used, tracking error increases as sector bets increase.
The Effects of Beta on Tracking Error
Tracking Error

0.00 0.50 1.00 1.50 2.00

Beta
Why is it important to monitor the portfolio tracking
error?

Probability of dramatic shortfall (active return < -10%)

rises with tracking error
Probability of dramatic outperformance also rises with
tracking error
Management consequences of the two are asymmetric
 Probability of a dramatic shortfall rises with tracking error

40%
Probability of Shortfall

35%
30%
25%
20%
15%
10%
5%
0%
0% 5% 10% 15% 20% 25%
Tracking Error

Note: 1) Dramatic shortfall is assumed to be a shortfall of 10% or more. 2) Portfolio excess returns
w ere assumed to be normally distributed. 3) Portfolio alpha w as set at -0.93%. During the 15 years
ended Sept 2002, the median active domestic large cap stock fund had an annalized return that w as
0.93% low er than that of the S&P 500 over that period, according to Morningstar.
Appendix
 Tracking Error of Enhanced Index Fund

Suppose, enhanced index fund = 10% active + 90% indexed

Let tracking error of active = 5%
Then, tracking error of enhanced index fund = 5%*10% = 0.5%

Subscripts: p = enhanced index portfolio; i = indexed portfolio; b = benchmark; a = active

Notation: r = return; w = weight; Var = variance; std = standard deviation; Corr = correlation

rp = wi*ri + wa*ra

rp rb = wi*(ri - rb) + wa*(ra - rb), since wi + wa = 1.

Var ( rp - rb ) = Var {wi*(ri - rb)} + Var {wa*(ra - rb)} + 2*wi*wa*Corr(ri - rb, ra - rb)*std(ri - rb)* std(ra - rb)

Var ( rp - rb ) = Var {wa*(ra - rb )} since ri = rb

std( rp - rb ) = wa*std(ra - rb)

 Tracking error rises with benchmark volatility

Subscript: p = portfolio; b = benchmark

Notation: r= return in excess of cash; e = error term; Var = variance;
= beta in a single index market model

rp = *rb + e

rp - rb = (-1)*rb + e

Var(rp - rb) = (-1)2 * Var(rb) + Var(e)

There would be no correlation between rb and the error term due to the regression.
 Tracking error and beta

Consider a combination of the market portfolio and cash.

Subscript: m = market in the context of a single index market model; p = portfolio

Notation: r = return in excess of cash; w = weight; = beta; Var = variance;
Cov = covariance; = absolute value

rp = w*rm + (1-w)*0 = w*rm , since the excess return of cash is zero.

= Cov(rp , rm) / Var(rm) = w * Var(rm) / Var(rm) = w

rp - rm = (w-1)*rm = (-1)*rm

Var (rp - rm) = (w-1)2 * Var(rm) = (-1)2 * Var(rm)

Tracking error = w-1 * std(rm) = -1 * std(rm)