The Use and Misuse of Tracking Error

Published in The Journal of Portfolio Management, August 2023.

Executive summary

Fixed tracking-error mandates are the standard fiduciary control on active equity, but the benchmark itself is not stable. Cap-weighted indexes, especially the S&P 500, swing between concentrated and diversified states over time, which changes what a given tracking-error level actually means for a skilled, diversified manager. Holding tracking error constant through those shifts is a misuse: when index concentration is high and rising, a fixed high-tracking-error manager is forced to hug an increasingly undiversified benchmark; when concentration is low and falling, the same constraint prevents the manager from exploiting dispersion.

Using CART on 1991-2022 data, the authors show large return spreads between high- and low-tracking-error strategies depending on index concentration level, concentration trend, and cross-sectional return dispersion. High tracking error wins when concentration is low or falling and dispersion is high, with spreads up to roughly 600 bps annually; low tracking error wins when concentration is high or rising, when high tracking error can lag by roughly 400 bps. The benchmark behaves like a chameleon, yet sponsors often cement a fixed tracking-error range against it. Remedies include tactical tracking-error flexibility, peer comparisons, better-diversified benchmarks such as equal weight, or wider prescribed tracking-error bands.

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