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IAI Actuarial Core Principles · Economic Modelling · Measures of investment risk

A fund manager's portfolio is benchmarked against the Nifty 50 index. Which of the following best defines the ex-post tracking error of the portfolio?

Tracking error is the standard deviation of the differences between portfolio returns and benchmark returns, i.e. the volatility of active return. It shows how closely the portfolio follows its benchmark, not how large the average outperformance is.

  1. AThe average of the portfolio return minus the benchmark return over the period
  2. BThe standard deviation of the differences between portfolio returns and benchmark returnsCorrect
  3. CThe standard deviation of the portfolio returns alone
  4. DThe covariance between portfolio returns and benchmark returns
  5. The portfolio beta multiplied by the benchmark standard deviation

Explanation

Tracking error measures how variable the active return (portfolio minus benchmark) is, so it is the standard deviation of those differences. The average difference is the mean active return, not tracking error. Total portfolio volatility ignores the benchmark entirely.

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