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 for index ETFs or mutual funds is, and how to calculate it. Learn about the difference it ... Read Answer >>
  2. How do you calculate variance in Excel?

    To calculate statistical variance in Microsoft Excel, use the built-in Excel function VAR. Read Answer >>
  3. How can I measure portfolio variance?

    Find out more about portfolio variance, the formula to calculate portfolio variance and how to calculate the variance of ... Read Answer >>
Related Articles
  1. 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.
  2. 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.
  3. Financial Advisor

    Does Your Investment Manager Measure Up?

    These key stats will reveal whether your advisor is a league leader or a benchwarmer.
  4. Investing

    Active Share Measures Active Management

    Active Share determines the extent of active management being employed by mutual fund managers.
  5. Investing

    How Investment Risk Is Quantified

    FInancial advisors and wealth management firms use a variety of tools based in modern portfolio theory to quantify investment risk.
  6. Investing

    9 Cognitive Biases That Affect Your Business

    Human beings often act irrationally when it comes to business decisions. Behavioral finance explains the difference between what we should do and what we do.
  7. Investing

    3 Index Funds with the Lowest Expense Ratios

    Read detailed information about index mutual funds with some of the lowest expense ratios in their categories, and learn about their pros and cons.
  8. Personal Finance

    There's Help Coming For Your Credit Report

    Soon, there will be another body protecting consumers when it comes to credit scores. Here are some new things to know about getting a credit report in the future.
  9. Investing

    Benchmark Your Returns With Indexes

    If your portfolio is always falling short, you may not be making an apples-to-apples comparison.
  10. Investing

    Base Your Return Needs on Risk Tolerance and Goals

    Having a financial goal stipulates the investment return you need.
RELATED TERMS
  1. Ex-Post Risk

    Ex-post risk is a risk measurement technique that uses historic ...
  2. Tracking Error

    Tracking error tells the difference between the performance of ...
  3. Benchmark Error

    Benchmark error occurs when an inappropriate benchmark is used ...
  4. Error Of Principle

    An error of principle is an accounting mistake in which an entry ...
  5. Transposition Error

    A simple error of data entry. Transposition errors occur when ...
  6. Non-Sampling Error

    A non-sampling error is an error that results during data collection, ...
Hot Definitions
  1. Gross Margin

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

    Inflation is the rate at which prices for goods and services is rising and the worth of currency is dropping.
  3. Discount Rate

    Discount rate is the interest rate charged to commercial banks and other depository institutions for loans received from ...
  4. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  5. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  6. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
Trading Center