What is a tracking error?

What is a tracking error?

• A. A measurable difference between the portfolio's return and the benchmark's return
• B. The variance of a portfolio's returns from year to year
• C. The correlation between two assets in the portfolio
• D. The expected inflation-adjusted return

Answer: (A)

Tracking error shows how far a portfolio’s performance deviates from its benchmark over time. It isn’t about how volatile the portfolio is on its own, but about the differences between the portfolio returns and the benchmark returns across periods. In practice you look at the series of monthly (or quarterly) differences r_p,t − r_b,t and measure its variability, typically the standard deviation. A small tracking error means the portfolio closely follows the benchmark; a larger tracking error indicates more active deviation. So the option describing a measurable difference between the portfolio’s return and the benchmark’s return matches this concept. The other ideas refer to different concepts: volatility of the portfolio’s own returns, correlations between assets, or inflation-adjusted (real) returns, none of which capture how closely the portfolio tracks the benchmark.

Tracking error shows how far a portfolio’s performance deviates from its benchmark over time. It isn’t about how volatile the portfolio is on its own, but about the differences between the portfolio returns and the benchmark returns across periods. In practice you look at the series of monthly (or quarterly) differences r_p,t − r_b,t and measure its variability, typically the standard deviation. A small tracking error means the portfolio closely follows the benchmark; a larger tracking error indicates more active deviation.

So the option describing a measurable difference between the portfolio’s return and the benchmark’s return matches this concept. The other ideas refer to different concepts: volatility of the portfolio’s own returns, correlations between assets, or inflation-adjusted (real) returns, none of which capture how closely the portfolio tracks the benchmark.