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NISM Certifications · NISM-Series-X-A: Investment Adviser (Level 1) · Portfolio Performance Measurement and Evaluation

In performance measurement, a portfolio's return is compared against a benchmark index. Which of the following is the best description of 'tracking error'?

Tracking error is the standard deviation of the differences between a portfolio's returns and its benchmark's returns. It shows how closely, or how erratically, the portfolio follows the benchmark over time. A low value means close tracking; a high value means large deviations from the benchmark.

  1. AThe average annual return earned above the risk-free rate
  2. BThe standard deviation of the difference between portfolio returns and benchmark returnsCorrect
  3. CThe difference between the highest and lowest annual returns of the portfolio
  4. DThe portfolio's beta multiplied by the market risk premium

Explanation

Tracking error measures how consistently a portfolio follows its benchmark. It is computed as the standard deviation of the active return, i.e. portfolio return minus benchmark return. The first option describes excess return, and the last resembles a CAPM-based expected premium, not a dispersion measure.

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