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. What are the advantages and disadvantages of zero-based budgeting in accounting?

    Learn how the information ratio is calculated as a risk-adjusted measure of performance, and understand how it seeks to differentiate ... Read Answer >>
  5. How do financial markets react to recessions?

    Learn more about the relationship between recessions and financial markets by identifying the fundamental characteristics ... 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

    How to Use a Benchmark to Evaluate a Portfolio

    What is an investment benchmark and how is it used to evaluate the risk and return in a portfolio.
  3. Investing

    What's a Benchmark?

    A benchmark is a standard investors choose to gauge the performance of their portfolios.
  4. 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.
  5. Investing

    The Hidden Differences Between Index Funds

    These funds don't all match index returns. Find out how to avoid costly surprises.
  6. Investing

    Explaining Standard Error

    Standard error is a statistical term that measures the accuracy with which a sample represents a population.
  7. 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.
  8. Investing

    Active Share Measures Active Management

    A 2006 study proves the effectiveness of a new way of sizing up your portfolio manager.
  9. Investing

    Avoid ETFs With These 6 Traits

    ETFs track a wide range of assets, charge smaller management fees than mutual funds, and they are usually liquid. But there are duds among the jewels.
RELATED TERMS
  1. Accounting Error

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

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

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

    A statistics term indicating that the variance of the errors ...
  5. Transposition Error

    A simple error of data entry. Transposition errors occur when ...
  6. Rounding Error

    A mathematical miscalculation caused by altering a number to ...
Hot Definitions
  1. Preferred Stock

    A class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shares ...
  2. Net Profit Margin

    Net Margin is the ratio of net profits to revenues for a company or business segment - typically expressed as a percentage ...
  3. Gross Margin

    A company's total sales revenue minus its cost of goods sold, divided by the total sales revenue, expressed as a percentage. ...
  4. Current Ratio

    The current ratio is a liquidity ratio measuring a company's ability to pay short-term and long-term obligations, also known ...
  5. SEC Form 13F

    A filing with the Securities and Exchange Commission (SEC), also known as the Information Required of Institutional Investment ...
  6. Quantitative Easing

    An unconventional monetary policy in which a central bank purchases private sector financial assets in order to lower interest ...
Trading Center