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

A risk manager compares ex-ante tracking error forecasts of 3.0% for a long-only equity fund with the realized tracking error of 4.5% over the past three years. Which is the most appropriate interpretation and response?

Realized tracking error of 4.5% well above the 3.0% forecast suggests the risk model may understate active risk, perhaps through changing exposures or correlations, so the model should be reviewed. Tracking error does not determine information ratio sign, and forecasts are not infallible.

  1. AThe forecast model may be underestimating active risk, for example from unstable factor exposures or changing correlations, and should be reviewedCorrect
  2. BThe realized figure is irrelevant because ex-ante tracking error is by definition always correct
  3. CThe fund must have a negative information ratio
  4. DThe difference shows the benchmark was mis-specified, so tracking error should be set to zero

Explanation

A realized tracking error well above the forecast signals potential model misspecification such as stale covariances, style drift or unmodeled risks. Realized and forecast values need not match, but a persistent gap warrants review. Tracking error says nothing about the sign of the information ratio.

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