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Tracking Error

This statistic measures the standard deviation of a fund's excess returns over the returns of an index or benchmark portfolio. As such, it can be an indication of 'riskiness' in the manager's investment style. A Tracking Error below 2 suggests a passive approach, with a close fit between the fund and its benchmark. At 3 and above the correlation is progressively looser: the manager will be deploying a more active investment style, and taking bigger positions relative to the benchmark's composition.
While zero Tracking Error would indicate a fund that was a perfect replication of its benchmark portfolio, this is hardly likely to be encountered in reality. The fund will not be fully invested at all times in its benchmark components, since an element of liquidity will need to be retained for redemptions, and the assumed reinvestment of dividends will not always be possible. Transaction costs dilute returns, and proportionately more so in smaller funds. Issues of timing and availability mean that changes in the benchmark's constituents cannot be instantaneously mirrored in the fund's portfolio. These factors will all produce greater Tracking Error - and be reflected in the Beta and R-squared ratios. But ultimately, of course, this is actually only an 'error' if the investment strategy goes unrewarded by out performance of the benchmark.

Worked Example: Information Ratio & Tracking Error
If Tracking Error (TE) is an indicator of how active a fund manager's investment activity is, Information Ratio (IR) will measure the extent to which the manager's investment-picking skill has been rewarded. In the following table we can examine two funds that have raised TEs, and which have generated positive IR.

Table 3. Ratios table over 36 months (from 31 Aug 2002 to 31 Aug 2005) against benchmark "UT UK Smaller Companies" (risk free rate at 3.5%) from Unit Trust/OEIC universe
Name Alpha Beta Sharpe Info Ratio Tracking Error
Aberforth UK Small Cos TR 4.54 0.85 1.61 0.36 4.02
Barclays Smaller Cos TR -4.55 1.11 0.94 -0.57 4.38
Capita Canlife UK Smaller Cos TR -1.49 1.06 1.09 -0.07 6.6
Framlington UK Smaller Cos TR 5.71 1.21 1.68 1.6 6.04
Sector: UT UK Smaller Cos TR 0 1 1.3 0 0

Aberforth's TE indicates a measure of active management, while its IR records that this has been rewarded to a reasonable, if unremarkable, extent. Framlington has a Sharpe Ratio in the same range, but its TE is half as much again as Aberforth's. Some investors could feel nervous about this level of volatility in the fund's investment activity, but the IR of 1.6 is evidence of the outstanding performance that has resulted from venturing away from the sector's composition.
This is further illustrated in the next table where, over any appreciable length of time, Framlington has substantially outperformed its sector-mates.

Table 4. Total return standard performance table from Unit Trust/OEIC universe
Name 1m 3m 6m 1y 3y
Aberforth UK Small Cos TR 2.57 6.18 6.7 29.64 102.28
Barclays Smaller Cos TR 2.2 6.36 2.97 24.92 85.34
Capita Canlife UK Smaller Cos TR 6.39 15.83 5.21 22.7 103.01
Framlington UK Smaller Cos TR 5.31 13.28 7.28 49.43 174.93
Sector: UT UK Smaller Cos TR 3.14 9.17 4.69 29.06 100.19

The final point about active management interventions is clear from the Barclays and Capita funds. Their TEs are marginally higher than the other funds in this example, but the managers' bets on more volatile stocks are not paying off, and we can see this in the negative IRs.
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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.

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