track(ing) error

As we are in an Olympic year, I wanted to talk a bit about my favourite event. The one I could just about manage in school sports day, the 800m.

Imagine you are preparing for your own 800m race. You have time to plan, train, get yourself ready. There is lots to consider, including your tactics for running the race. Do you stay with the pack or do you go out on your own?
Imagine the stock market is the race. Lots of runners, mainly running in a pack, are the average investors or the ‘benchmark’. If you decide to run in this pack you would expect to achieve an average time or benchmark return. These runners would say they exhibit a low tracking error.

Now, lets say you want to do something different. You want to deploy different tactics to the field, for example, running in intervals or using an energy saving technique to slowly build pace as the race develops. Taking a different approach to the pack should yield a different result in terms of time. In our analogy these investors could have a different result from the benchmark, which would manifest itself as a higher tracking error.

Tracking error is an important concept in investment and particularly when thinking about portfolio management. Tracking error measures the difference in your portfolio or fund vs the benchmark composition. Even passive funds and ETFs will have some deviation to the benchmark albeit very low.
Active funds on the other hand should be more willing to have a higher tracking error in order to differentiate themselves from the benchmark and give themselves a chance to achieve better returns.

Tracking error should be a key metric when assessing a portfolio to ensure you are achieving what the aims of the portfolio are. If you want to run with the pack and achieve the average then that’s what you should do but if you want to try and ‘beat the market’ or achieve a better than average time, you will have to take on tracking error.

This isn’t just a shameless plug for active management (although I am an advocate) as I believe there is space for both active and passive in an efficient portfolio. However, if you are going to trust an active manager then knowing they are truly differentiated is important and using tracking error can highlight this for the end client.

What is always important is that you have to run your own race in whatever way you feel most comfortable.