Market Risk - What is significance of Tracking error

[AbhishekJha]

Hi,

In chapter 1 , Page 9 - the Market risk is explained as - "Market risk specifically depends on the context. For example, In the case of a fund, the fund may be marketed as tracking a specific benchmark. Here, market risk is important to the extent that it creates a risk of tracking error."

What is the meaning of "Tracking error" in this context?

 

[David Harper CFA FRM]

Hi @AbhishekJha As you suggest (via context), the term "tracking error" is has occasionally different definitions. In the FRM, tracking error should be active risk: the standard deviation (aka, volatility) difference in returns between the portfolio and the benchmark. As explained in my video here at https://forum.bionicturtle.com/threads/t1-11-information-ratio.21447/

But in the context you cite, I think it just means what we would otherwise call relative (return) risk. If you track a benchmark, and the benchmark drops -9.0% but your fund drops only -5.0%, then you outperformed the benchmark. If the fund gains +5.0% but the benchmark gains +11.0%, then you underperformed. So the point is that instead of absolute return risk (where +5.0% is a gain and -5.0% is a loss), tracking error here is the risk of relative (to the benchmark) underperformance where +5.0% can be a relative loss but -5.0% can be a relative (to the benchmark) gain. Hope that's helpful,

 

[AbhishekJha]

Hi @AbhishekJha As you suggest (via context), the term "tracking error" is has occasionally different definitions. In the FRM, tracking error should be active risk: the standard deviation (aka, volatility) difference in returns between the portfolio and the benchmark. As explained in my video here at https://forum.bionicturtle.com/threads/t1-11-information-ratio.21447/

But in the context you cite, I think it just means what we would otherwise call relative (return) risk. If you track a benchmark, and the benchmark drops -9.0% but your fund drops only -5.0%, then you outperformed the benchmark. If the fund gains +5.0% but the benchmark gains +11.0%, then you underperformed. So the point is that instead of absolute return risk (where +5.0% is a gain and -5.0% is a loss), tracking error here is the risk of relative (to the benchmark) underperformance where +5.0% can be a relative loss but -5.0% can be a relative (to the benchmark) gain. Hope that's helpful,

Thank You!