This article provides a high-level refresher of what tracking error means, and how we can embed it directly into portfolio construction.
When we design a benchmarked portfolio, every design choice that takes us away from the benchmark has a consequence, and every consequence has a risk. Tracking error (TE) – the humble statistic that serves as a measure of this risk – is having its day in the sun again due to its use in passive sustainable investing. It has become so prevalent, however, that its meaning can often be obscured. Intuitively, we know that a portfolio with a 1% tracking error is “closer” to its benchmark than a portfolio with a 5% tracking error, but how should we interpret the degree of difference? What does it imply for the future? And can we control this?