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

A manager reduces tracking error by moving the portfolio closer to the benchmark weights. Which statement is most accurate?

Expected active return typically falls, because narrowing the gap to the benchmark reduces both relative risk and the room for outperformance. Absolute risk remains largely that of the benchmark, and the information ratio need not improve.

  1. ATotal portfolio volatility must fall below that of the benchmark
  2. BAbsolute risk is eliminated
  3. CThe portfolio's beta must become zero
  4. DExpected active return typically falls as the portfolio's scope for outperformance narrowsCorrect
  5. The information ratio must rise

Explanation

Moving closer to the benchmark cuts relative risk but also limits the active positions that generate outperformance. Total risk stays tied to the market's risk, so it does not vanish or fall below benchmark necessarily. The information ratio can go either way.

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