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. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  2. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  3. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  4. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>
  5. How do you know where on the oscillator you should make a purchase or sale?

    Common oscillator readings to consider making a buy or sale are below 20 or above 80, respectively. More aggressive investors ... Read Full Answer >>
  6. What are some of the more common types of regressions investors can use?

    The most common types of regression an investor can use are linear regressions and multiple linear regressions. Regressions ... Read Full Answer >>
Related Articles
  1. Technical Indicators

    Use Market Volume Data to Determine a Bottom

    Market bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls.
  2. Mutual Funds & ETFs

    Top 3 Switzerland ETFs

    Explore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
  3. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  4. Trading Strategies

    The Top Spread-Betting Strategies

    What are the most commonly followed spread-betting strategies (in countries where it's legal)?
  5. Trading Strategies

    Who Actually Trades or Invests In Penny Stocks?

    Although penny stocks are highly speculative, millions of people trade them daily. Here are 10 different types who do.
  6. Chart Advisor

    4 Stocks Still Flashing Buy Signals

    In the midst of volatility and a big market sell-off last week, these stocks are flashing buy signals.
  7. Technical Indicators

    Understanding Trend Analysis

    Trend analysis is the use of past performance to predict future price movement of a security.
  8. Economics

    The Problem With Today’s Headline Economic Data

    Headwinds have kept the U.S. growth more moderate than in the past–including leverage levels and an aging population—and the latest GDP revisions prove it.
  9. Economics

    Explaining the Participation Rate

    The participation rate is the percentage of civilians who are either employed or unemployed and looking for a job.
  10. Mutual Funds & ETFs

    ETF Analysis: Guggenheim Enhanced Short Dur

    Find out about the Guggenheim Enhanced Short Duration ETF, and learn detailed information about this fund that focuses on fixed-income securities.
RELATED TERMS
  1. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth ...
  2. Altman Z-Score

    The output of a credit-strength test that gauges a publicly traded ...
  3. Fintech

    Fintech is a portmanteau of financial technology that describes ...
  4. Indicator

    Indicators are statistics used to measure current conditions ...
  5. Intraday Momentum Index (IMI)

    A technical indicator that combines aspects of candlestick analysis ...
  6. Forex Spread Betting

    A category of spread betting that involves taking a bet on the ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!