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FRM Part II · FRM Exam Part II · Portfolio Performance Evaluation

A risk officer sees that a fund's realized tracking error is 1.0%, far below the 4.0% limit, yet the fund holds a large overweight to one sector relative to the benchmark. Which explanation is most consistent with this observation?

Realized tracking error looks backward, so it can understate current risk when a large sector overweight was added recently. An ex-ante tracking error based on current holdings and covariances would better capture the concentrated bet relative to the benchmark.

  1. ARealized tracking error is backward-looking and may understate risk if the sector bet was recently addedCorrect
  2. BTracking error always captures sector concentration immediately, so the bet is not risky
  3. CA low tracking error implies the portfolio beta is zero
  4. DLow tracking error means the information ratio must be high

Explanation

Realized (ex-post) tracking error is based on past active returns, so a newly built concentrated position is not yet reflected; ex-ante measures using current holdings are needed. Tracking error does not imply zero beta, and the information ratio also depends on active return, so it is not necessarily high.

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