Tracking Error Fund Benchmark Active Dev from Squared Period ReturnReturn Return

Question

Tracking Error Fund Benchmark Active Dev from Squared Period ReturnReturn Return MeanDeviation 10.00-0 5.00 9.50 4.50 -2.50 5.00 2.5 4 9.50 10.00-0. 5 4.505.00 6 -2.50 5.00 25 Sum Mean 0. Variance 2 STDEV 2. a.) What is the tracking error for this portfolio? b.) Interpret your answer c.) Suppose there is another portfolio with an alpha (mean active return) of 0.75 and a tracking error of 1.75.. How might you choose between the two? Assume that the only relevant data are the alpha and the tracking error.

Explanation / Answer

Solution:

a.

Tracking error = Active return/(N – 1)

Tracking error = 3/5

Tracking error = 0.6 = 0.775

b. This indicates that the active risk is 0.775.

c. Tracking error sets expectation how large the difference between the benchmark and the portfolio return whereas alpha measure the value of active tax management.

Period Fund return % Benchmark return % Active return % Dev from mean Squared deviation 1 9.5 10 -0.5 5.67 32.11 2 4.5 5 -0.5 0.67 0.44 3 -2.5 -5 2.5 -6.33 40.11 4 9.5 10 -0.5 5.67 32.11 5 4.5 5 -0.5 0.67 0.44 6 -2.5 -5 2.5 -6.33 40.11 Sum 23 20 3 0 145.33 Mean 3.83 3.33 0.50 Variance 29.07 46.67 2.40 STDEV 5.39 6.83 1.55

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