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

A portfolio manager's fund returns exceeded the benchmark's returns by the following amounts over four periods: +2%, -1%, +3%, 0%. Ignoring any adjustment beyond the simple definition, which statement best describes how tracking error is defined for this fund?

Tracking error is the standard deviation of active returns, meaning the portfolio return minus the benchmark return. It measures how variable the excess performance is relative to the benchmark, not the average excess return or the portfolio's total volatility.

  1. AThe standard deviation of the active returns (portfolio return minus benchmark return)Correct
  2. BThe average of the active returns
  3. CThe standard deviation of the portfolio's total returns
  4. DThe portfolio's beta relative to the benchmark

Explanation

Tracking error measures the dispersion of active returns, i.e., the standard deviation of portfolio return minus benchmark return. The average active return is the active return (alpha-like), not risk. Total return standard deviation ignores the benchmark.

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