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FRM Part II · FRM Exam Part II · Portfolio Risk: Analytical Methods

A portfolio manager's fund returned 8.4% last year against a benchmark return of 7.1%. Over the same period, the standard deviation of the fund's monthly active returns (fund minus benchmark), annualized, was 2.6%. Which statement best describes the tracking error of the fund?

Tracking error is the standard deviation of the difference between portfolio and benchmark returns, so it equals 2.6% annualized. The 1.3% excess return is the active return, and dividing it by tracking error gives the information ratio of 0.5, not tracking error.

  1. A1.3%, the difference between the fund and benchmark returns
  2. B2.6%, the annualized standard deviation of active returnsCorrect
  3. C7.1%, the volatility of the benchmark
  4. D0.5, the ratio of active return to tracking error

Explanation

Tracking error is defined as the standard deviation of active returns (portfolio minus benchmark). Here that is the annualized 2.6%. The 1.3% figure is the active return itself (8.4% - 7.1%), not a risk measure. The ratio 1.3/2.6 = 0.5 is the information ratio.

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