A few weeks ago we began a discussion on portfolio management. In my first posting, we discussed how it is possible to be too diversified. Last week we uncovered a major flaw in some advisors’ use of Monte Carlo simulation. This week, we’ll look at “tracking error” and why I believe it holds much less significance than many believe.
Investopedia.com defines tracking error as, “A divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark.” Tracking error is frequently used to measure the degree to which a particular mutual fund strays from its peer group. Its proponents believe that a fund should stay true to its peers, and hence, have a low tracking error. In the past I would have agreed.
However, when things get bad and the bottom is falling out of the financial markets, I would prefer to have managers who have the ability to increase their allocation to cash to avoid a large loss. There are a few funds that did this in 2008 to help protect shareholders. However, because of this flexibility, they also have a higher tracking error. Hence, my point that tracking error may not be that significant.
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Tracking Error and Index Investing