What is tracking error in quantitative research?
October 12, 2016 in Quantitative Methods. Tracking error refers to the difference in returns between a portfolio (index fund) and a benchmark (target index) against which its performance is evaluated. In other words, it is the difference between the returns on an index fund and the returns on a target index.
What does a large tracking error indicate?
The larger the difference between the index fund return and the target index return, the higher the tracking error. A large tracking error may be indicative of poor performance. 1.
What is the difference between tracking difference and tracking error?
Tracking difference is rarely nil: The ETF usually trails its index. That’s because a number of factors prevent the ETF from perfectly mimicking its index. ETF returns don’t always trail their index though; tracking difference can be small or large, positive or negative. Tracking error is a related but distinct metric.
What are the tracking errors for the portfolio?
In this case, the tracking errors for the portfolio will be 1.5%. It helps the investors of a fund to understand whether the fund is closely tracking and replicating the components of the index it is putting up as a benchmark.
What is a big tracking error?
If a manager is realizing low average returns and has a large tracking error, it is a sign that there is something significantly wrong with that investment and that the investor should most likely find a replacement.
What is a good tracking error ETF?
The lower the tracking error, the more closely the ETF matches the benchmark. Under normal circumstances, such tracking errors are not expected to exceed 2% per annum.
How do you interpret tracking error?
Interpreting the Tracking Error A fund manager is said to perform well if they are able to replicate the return earned on the target index. The larger the difference between the index fund return and the target index return, the higher the tracking error. A large tracking error may be indicative of poor performance.
What does low tracking error mean?
Low tracking error means a portfolio is closely following its benchmark. High tracking errors indicates the opposite. Thus, tracking error gives investors a sense of how 'tight' the portfolio in question is around its benchmark or how volatile the portfolio is relative to its benchmark.
Can you have a negative tracking error?
It's important to remember that tracking error describes the size of the difference in relative return, not whether it was positive or negative. But the greater the tracking error, the greater the possibility for very negative or very positive excess returns.
Should tracking error be Annualized?
In order to make the tracking error comparable it should be annualised. In order to do the right right of the equation should be multiplied by the number of periods in an year. Equivalents σ multiplied by the root of the number of periods in an year.
What is tracking error with example?
Let's say that XYZ Fund is supposed to track the Big Stock Index. Last year, the Big Stock Index returned 10% while the XYZ Fund returned 9.7%. The difference between the two, 9.7% - 10% = -0.3%, is the tracking error.
Is tracking error a measure of risk?
Tracking error, also known as active risk, measures, in standard deviation, the fluctuation of returns of a portfolio relative to the fluctuation of returns of a reference index. It is a measure of the risk in an investment portfolio arising from active management decisions made by the portfolio manager.
What is a good Sharpe ratio?
Generally speaking, a Sharpe ratio between 1 and 2 is considered good. A ratio between 2 and 3 is very good, and any result higher than 3 is excellent.
Is tracking error same as volatility?
Tracking Error is a measure of how well the fund tracks the benchmark during the investment period. It is a measure of volatility. A small tracking error indicates that the passive fund will tend to follow its benchmark very closely throughout, whereas a large tracking error indicates the opposite.
Is a higher active risk better?
High active risk indicates the opposite. Thus, active risk gives investors a sense of how “tight” the portfolio in question is around its benchmark or how volatile the portfolio is relative to its benchmark.
What is an average tracking error for ETF?
Bank ETFs had a median tracking error of 3.9 while the median for technology ETFs, including pharmaceuticals and biotechnology, was 3.4.
How do you track ETF errors?
The tracking error of ETFs is computed based on their NAVs, which is the closing price of the day and not the actual price at which an investor bought or sold units. So, the computed tracking error is just an indicative number and not the actual difference between index returns and investor returns.
Is tracking error a concern for fixed income ETFs?
Although rarely considered by the average investor, tracking errors can have an unexpected material effect on an investor's returns. It is important to investigate this aspect of any ETF index fund before committing any money to it.
Is tracking error a concern for commodity ETFs?
Tracking error may be a concern to exchange-traded fund (ETF) investors.
What Is a Tracking Error?
Tracking error is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark. This is often in the context of a hedge fund , mutual fund , or exchange-traded fund (ETF) that did not work as effectively as intended, creating an unexpected profit or loss.
What factors affect tracking error?
One important factor is the extent to which a fund's holdings match the holdings of the underlying index or benchmark. Many funds are made up of just the fund manager's idea of a representative sample of the securities that make up the actual index. There are frequently also differences in weighting between a fund's assets and the assets of the index.
Why are ETFs not following benchmark indexes?
International ETFs with currency hedging may not follow a benchmark index due to the costs of currency hedging, which are not always embodied in the MER. Factors affecting hedging costs include market volatility and interest-rate differentials, which impact the pricing and performance of forward contracts.
What is the purpose of evaluating a past tracking error?
Evaluating a past tracking error of a portfolio manager may provide insight into the level of benchmark risk control the manager may demonstrate in the future.
Why is NAV lower than benchmark?
The net asset value (NAV) of an index fund is naturally inclined toward being lower than its benchmark because funds have fees, whereas an index does not. A high expense ratio for a fund can have a significantly negative impact on the fund's performance. However, it is possible for fund managers to overcome the negative impact of fund fees and outperform the underlying index by doing an above-average job of portfolio rebalancing, managing dividends or interest payments, or securities lending.
Which ETFs have the highest tracking error?
Sector , international , and dividend ETFs tend to have higher absolute tracking errors; broad-based equity and bond ETFs tend to have lower ones. Management expense ratios (MER) are the most prominent cause of tracking error and there tends to be a direct correlation between the size of the MER and tracking error. But other factors can intercede and be more significant at times.
Does illiquid stock increase tracking error?
Illiquid or thinly-traded securities can also increase the chance of a tracking error, since this often leads to prices differing significantly from market price when the fund buys or sells such securities as a result of larger bid-ask spreads. Finally, the level of volatility for an index can also affect the tracking error.
What is tracking error?
Tracking error refers to the difference in returns between a portfolio (index fund) and a benchmark (target index) against which its performance is evaluated. In other words, it is the difference between the returns on an index fund and the returns on a target index.
Why must a manager keep expenditures in check?
The manager must keep expenditures in check if they are to replicate the target index performance. 2. It may indicate management’s efficiency as far as cash is concerned: The need to meet dividend payments and requests for redemption means that a fund’s management must always set aside some cash.
What happens if management holds too much cash?
If the management holds too much cash, then it means less funds will be invested thereby increasing the tracking error. If too little cash is held, the tracking error will be smaller. However, the company might not be able to meet its liabilities, a situation which may lead to a takeover.
Why do I watch videos before reading?
I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
Why do you use tracking error?
You can use tracking error to analyze a new fund or to ensure an existing investment is doing what it should be. If you’re looking for an index fund to diversify your portfolio, make sure it has low tracking error so that your returns aren’t being eaten away by costs. If you pay more for an actively managed fund to try to beat the market, you don’t want low tracking error because you could just buy an index fund and get the same result, in theory.
When analyzing a fund, can you use tracking error?
When analyzing a fund, you can use tracking error to find how consistently the fund tracks the index and tracking difference to find how close the performance is.
What is the tracking error for SPY 2021?
According to Fidelity, SPY’s tracking error in August 2021 is just 0.03. The asset class median is 10.41, which means the standard deviation of the difference in SPY’s returns and the actual S&P 500’s is low compared to other ETFs with the same stocks. 1
What is tracking difference?
Tracking difference is the return difference over a specific time period between a portfolio and index while tracking error shows how often the portfolio has different returns.
How to reduce correlation to benchmark index?
If you’re looking for an investment that will reduce correlation to a benchmark index, tracking error from that index is the goal. And for active managers to outperform the index, they necessarily must increase “risk.”
What is tracking error?
Tracking error equals the difference between the index’s return and your tracker’s return.
Why is it easy to match up FTSE All Share trackers?
Matching up FTSE All-Share trackers is reasonably easy because the FTSE All-Share index is recognised by the financial tools available to retail investors.
Is tracking error important?
There are plenty of factors to consider when choosing a tracker but tracking error is the most important, which makes it a mighty shame that it’s so hard to get clean data for many indices. Acting on tracking error data is partly a judgement call, partly guesswork, partly deciding on your own tolerance levels.
Is comparison data 100% reliable?
Comparison data may not be 100% reliable.
Is it unfair to compare tracker to index?
Make sure you’re comparing the tracker against the index referenced as its benchmark on its factsheet – otherwise the comparison is unfair.
What is tracking error?
Tracking error is a measure of how consistent a portfolio’s return is with that of its benchmark. The term “tracking error” gets thrown around a lot in the industry, but it can refer to two different measurements, which creates confusion among investors during the due diligence process.
How to assess tracking error?
Assessing tracking error requires an in-depth analysis, especially when the error appears to be large. It’s important to consider multiple time periods and data points. By isolating, or “cherry-picking”, a particular period, you can be left with incomplete or misleading information. When an analysis is expanded beyond a single period to instead focus on rolling periods, trends may be revealed, like whether a fund’s tracking error is improving or deteriorating, or whether an aberration caused a sudden shift.
What does it mean when an ETF tracks a large tracking error?
A large tracking error between a passively managed ETF and the index it tracks may be a red flag. It could signal excessive trading costs or issues relating to fund management.
Why is tracking error higher in emerging market?
Tracking error can also be higher for strategies that hold less liquid securities, such as high yield bonds or emerging market debt because transacting in these securities tends to involve higher costs.
What is tracking return difference?
Tracking Return Difference: This is the difference between the index and an ETF’s net asset value (NAV) return. This figure can be negative or positive, and it measures the extent to which an ETF’s return differs from the index it seeks to track over a particular time period. The lower the absolute number, the better. However, tracking return difference is typically a negative number due to the impact an expense ratio has on returns. While an index’s return does not factor in expenses, an ETF’s does.
Is tracking error important in JNK?
Similar to measuring an ETF’s performance, capturing trends in tracking error are far more important than looking at just one single period.
Explanation
Tracking error is a measure to find out how much the return of a portfolio or a mutual fund deviates from the return of an index it is trying to replicate in terms of the components of an index and also in the term of the return of that index.
Examples
Let us try to do the calculation of the tracking error with the help of an arbitrary example, say for mutual fund A, which is tracking the oil and gas index. It is calculated by the difference in the return of the two variables.
Use of Tracking Error Formula
It helps the investors of a fund to understand whether the fund is closely tracking and replicating the components of the index it is putting up as a benchmark. It showcases whether the fund manager is trying to actively track the benchmark or he is putting his style in order to modify it.
Recommended Articles
This has been a guide to Tracking Error Formula. Here we discuss how to calculate tracking error for the portfolio along with examples and a downloadable excel template. You can learn more about financing from the following articles-
What Causes Tracking Errors?
Running an ETF index fund might seem like a simple job, but it can actually be quite difficult. ETF index fund managers often employ complex strategies in order to track their target index in real-time, with fewer costs and greater accuracy than their competitors.
What is the biggest contributor to tracking error?
Fund management and trading fees are often cited as the largest contributor to tracking error. It is easy to see that even if a given fund tracks the index perfectly, it will still underperform that index by the amount of the fees that are deducted from a fund's returns. Similarly, the more a fund trades securities in the market, the more trading fees it will accumulate, reducing returns.
What are the key metrics to look for in an ETF?
Make sure that the ETF index fund you are considering does a good job of tracking its index. Key metrics to look for here are the fund's R-squared and beta. R-squared is a statistical measure that indicates how well the index fund's price movements correlate with its benchmark index. The closer the R-squared is to one, the closer the index fund's ups and downs match those of the benchmark.
How much tracking error is in index funds?
Most of the time, the tracking error of an index fund is small, perhaps only a few tenths of one percent. However, a variety of factors can sometimes conspire to open a gap of several percentage points between the index fund and its target index. In order to avoid such an unwelcome surprise, index investors should understand how these gaps may develop.
Can tracking errors affect returns?
Tracking errors tend to be small, but they can still adversely affect your returns . Looking at metrics such as a fund's beta and R-squared can give a sense of how prone it is to tracking error.
Is it hard to run an ETF?
Running an ETF index fund might seem like a simple job, but it can actually be quite difficult. ETF index fund managers often employ complex strategies in order to track their target index in real-time, with fewer costs and greater accuracy than their competitors. Many market indexes are market-capitalization-weighted.
What is tracking error?
Tracking error is a related but distinct metric. Tracking error is about variability rather than performance. Math geeks measure variability through standard deviation. Tracking error is the annualized standard deviation of daily return differences between the total return performance of the fund and the total return performance of its underlying index.
Why is tracking difference nil?
Tracking difference is rarely nil: The ETF usually trails its index. That’s because a number of factors prevent the ETF from perfectly mimicking its index. ETF returns don’t always trail their index though; tracking difference can be small or large, positive or negative. Tracking error is a related but distinct metric.
What happens when an index rebalances?
When an index rebalances or reconstitutes its components, the changes are instantaneous. In contrast, an ETF tracking the index must go out and transact in order to realign itself with the index. During the time it takes to buy and sell the necessary securities, prices move and create tracking difference between the index and the ETF.
Does tracking difference increase with ETFs?
Those costs must be paid with the fund’s assets which , consequently, increases tracking difference . ETFs that track indexes with many securities, illiquid securities or that rebalance frequently by design (like an equal-weighted index) will incur greater transaction and rebalancing costs, which will increase tracking difference.
