How is a portfolio's tracking error calculated and what does it signify?

• A. Tracking error = the average difference between portfolio and benchmark returns.
• B. Tracking error = the covariance of portfolio and benchmark returns.
• C. Tracking error = standard deviation of the difference between portfolio and benchmark returns; measures how closely the portfolio tracks the benchmark.
• D. Tracking error = the correlation with the benchmark returns.

Answer: (C)

The idea being tested is how tracking error is measured and what it tells us about a portfolio’s relationship to its benchmark. Tracking error is the standard deviation of the differences between the portfolio’s returns and the benchmark’s returns (the active returns). This captures how much and how consistently the portfolio diverges from the benchmark over time, not just the average level of divergence. A small tracking error means the portfolio tends to move in lockstep with the benchmark, indicating tight tracking, while a larger tracking error signals greater deviation and hence more active risk. Other formulas like the average difference, covariance, or correlation don’t describe the variability of the deviation itself in the same way; the standard deviation of the differences is the metric that expresses both the magnitude and consistency of the tracking error. In practice, tracking error is often annualized and used to gauge the manager’s active risk relative to the benchmark.