A:

Before we answer your question, let's first define tracking error and ex-post risk. Tracking error refers to the amount by which the returns of a stock portfolio or a fund differ from those of a certain benchmark. As you might expect, a fund that has a high tracking error is not expected to follow the benchmark closely, and it is generally seen as being risky.

The other component of the question is ex-post risk, which is a measure of the variance of an asset's returns relative to a mean value. In other words, ex-post risk is the statistical variance of an asset's historical returns. Many individuals would argue that tracking error is not the best measure to determine ex-post risk because it looks at the returns of a portfolio relative to a benchmark rather than looking at the variability in the portfolio's returns. Tracking error can be a useful tool when determining how closely a portfolio mimics a stable benchmark, or how efficient a portfolio's manager is at tracking a benchmark, but many would argue that this is not a good measure of how much an investor can expect to gain or lose on any given trading day. However, ex-post risk, unlike tracking error, can provide an estimate of the probability that the expected return of a portfolio will drop by a certain amount on any given day, which is why it is a common risk metric used by professionals when studying things such as value at risk.

Using tracking error as a measure of ex-post risk would only make sense when tracking error is equal to zero because when an investor's portfolio consists of many stable companies that have produced predictable, stable returns, the historical variance of the benchmark's returns would be equal to those of the portfolio.

To learn more see, Introduction To Value At Risk (VAR) - Part 1 and Part 2 and Determining Risk And The Risk Pyramid.

RELATED FAQS
  1. How can I calculate the tracking error of an ETF or indexed mutual fund?

    Understand what tracking error is and learn about the significant difference it can represent for investors who favor index ... Read Answer >>
  2. How is the standard error used in trading?

    Understand how the standard error is used in statistics and what it measures. Learn how the standard error is used in trading ... Read Answer >>
  3. What is a relative standard error?

    Find out how to distinguish between mean, standard deviation, standard error and relative standard error in statistical survey ... Read Answer >>
  4. How do financial markets react to recessions?

    Learn more about the relationship between recessions and financial markets by identifying the fundamental characteristics ... Read Answer >>
  5. What is the difference between ex-ante moral hazard and ex-post moral hazard?

    Learn what moral hazard is, the difference between ex-ante moral hazard and ex-post moral hazard and the behavioral changes ... Read Answer >>
  6. How do I fix an error on my credit report?

    Take control over your credit report by disputing false claims, accounts and information to the three major credit reporting ... Read Answer >>
Related Articles
  1. Investing

    3 Reasons Tracking Error Matters

    Discover three ways investors can use tracking error to measure performance for a mutual fund or ETF, whether indexed or actively managed.
  2. Investing

    ETF Tracking Errors: Protect Your Returns

    Tracking errors tend to be small, but they can still adversely affect your returns. Learn how to protect against them.
  3. Financial Advisor

    Make Your Portfolio Safer With Risky Investments

    A high-risk security can reduce risk overall. Find out how it works.
  4. Investing

    How to Select and Build a Benchmark to Measure Portfolio Performance

    How to select and build a benchmark to measure the performance of your investment portfolio
  5. Trading

    3 Costly Spelling Errors

    History has proved that some spelling errors can cost companies and governments millions of dollars.
  6. Investing

    What's a Benchmark?

    A benchmark is a standard investors choose to gauge the performance of their portfolios.
  7. Financial Advisor

    Active Risk vs. Residual Risk: Differences and Examples

    Active risk and residual risk are common risk measurements in portfolio management. This article discusses them, their calculations and their main differences.
  8. Insurance

    What Does Errors and Omissions Insurance Cover?

    Errors and omissions insurance protects companies and individuals against claims made by clients for inadequate work or negligent actions.
  9. Investing

    Explaining Standard Error

    Standard error is a statistical term that measures the accuracy with which a sample represents a population.
RELATED TERMS
  1. Tracking Error

    A divergence between the price behavior of a position or a portfolio ...
  2. Accounting Error

    An error in an accounting item that was not caused intentionally. ...
  3. Non-Sampling Error

    A statistical error caused by human error to which a specific ...
  4. Error Of Principle

    An accounting mistake in which an entry is recorded in the incorrect ...
  5. Homoskedastic

    A statistics term indicating that the variance of the errors ...
  6. Rounding Error

    A mathematical miscalculation caused by altering a number to ...
Hot Definitions
  1. Interest Expense

    The cost incurred by an entity for borrowed funds. Interest expense is a non-operating expense shown on the income statement. ...
  2. Call Option

    An agreement that gives an investor the right (but not the obligation) to buy a stock, bond, commodity, or other instrument ...
  3. Pro-Rata

    Used to describe a proportionate allocation. A method of assigning an amount to a fraction, according to its share of the ...
  4. Private Placement

    The sale of securities to a relatively small number of select investors as a way of raising capital.
  5. AAA

    The highest possible rating assigned to the bonds of an issuer by credit rating agencies. An issuer that is rated AAA has ...
  6. Backward Integration

    A form of vertical integration that involves the purchase of suppliers. Companies will pursue backward integration when it ...
Trading Center