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Raman Vardharaj
Quantitative Portfolio Manager
Guardian Life Insurance
This presentation is based on the following unpublished paper: Determinants of tracking error for equity portfolios by Raman
Vardharaj, Frank Jones and Frank Fabozzi.
How do you measure the risk of a stock portfolio?
Rtn(BM) +4%
Benchmark
1 Std Dev
Cumulative
Rtn(Benchmark) or
Return 66% confident
Rtn(BM) -4%
Today Time
One year
from now
Tracking Error: An Example
Tracking Error = 1%
Cumulative
Return
Today Time
One year
from now
Determinants of tracking error
14%
12%
Large Cap
10%
Benchm ark: S&P 500
Tracking Error
8%
6%
4%
2%
0%
0 50 100 150 200 250 300 350 400 450 500
number of benchmark (S&P 500) stocks in the portfolio
Tracking Error Reduction Requires More Benchmark Stocks for
Mid Cap than for Large Cap
6%
Mid Cap
5%
Benchm ark: S&P 400
4%
Tracking Error
3%
2%
1%
0%
0 50 100 150 200 250 300 350 400
number of benchmark (S&P 400) stocks in the portfolio
Tracking Error Reduction Requires More Benchmark Stocks for
Small Cap than for Mid Cap
7%
6%
Small Cap
5%
Tracking Error
2%
1%
0%
0 50 100 150 200 250 300 350 400 450 500 550 600
number of benchmark (S&P 600) stocks in the portfolio
Tracking Error Rises With the Increase in Non-Benchmark Stocks
10%
Benchmark: S&P 100
9%
Tracking error
8%
Portfolio Universe: S&P 500
7%
6%
5%
100 150 200 250 300 350 400
number of non-benchmark (S&P 100) stocks in the portfolio
Note: All of the S&P 100 stocks are present in the S&P 500. We start w ith a portfolio that has all 100 of the stocks in the S&P 100 index and
progressively add to it stocks that are not in the S&P 100 index but are in the S&P 500 index. The tracking error for such a portfolio versus the
S&P 100 index is show n above. So, for example, w hen the portfolio has 200 of the S&P 500 stocks in addition to the S&P 100 stocks (i.e., 300 in all)
then its tracking error, upon optimal choice, is 6% as show n above.
Effect of size and style
1
2 4
5 7
Large
3
1
8, 88
Mid
66
33
11
Small
55 77
22 44
Investment valuation is along the horizontal axis and market cap (size) is along the vertical axis.
Large Cap
Portfolio 1 has a tracking error of 0%. Portfolios 2, 3, 4 have nearly similar tracking errors of around 2.1%.
Portfolios 5, 6, 7 have nearly similar tracking errors of around 4.2%. Portfolio 8 has a tracking error of
8.5%. All of the above tracking errors are versus the S&P 500, the large cap index.
Small Cap
Portfolio 11 has a tracking error of 0%. Portfolios 22, 33, 44 have nearly similar tracking errors of around
1.7%. Portfolios 55, 66, 77 have nearly similar tracking errors of around 3.4%. Portfolio 88 has a tracking
error of 4.9%. All of these tracking errors are versus the S&P 600, the small cap index.
Effect of sector bets and beta
12%
10%
8%
6%
4%
2%
0%
12/31/99
12/31/00
3/31/99
6/30/99
9/30/99
3/31/00
6/30/00
9/30/00
3/31/01
Abs Sector bet RMS Sector bet Tkg Err
Using data pertaining to an actual mutual fund, this figure illustrates that the fund's tracking error with respect to the S&P 500 increased during
the calendar year 2000 as the fund placed increasingly larger sector bets. The tracking error values are predictive estimates from Barra.
We define sector deviation as the fund portfolio weight in a sector in excess of the benchmark weight in that sector. By definition, the sum of
all sector deviations as well as their average would be zero. We define the "Abs S ector Bet" as the average of the absolute values of the sector
deviations. The "RMS S ector Bet" is the root mean square sector deviation. That is, we first square the sector deviations, and calculate
their average. Then, we find the square root of this average. This is the RM S sector bet. The Abs Sector Bet and the RM S sector bet are two
indicators of the overall level of sector bets in the portfolio. Notice that the RM S sector bet measure appears to move more closely in line with
the Tracking Error than the Abs sector bet measure. Irrespective of which measure is used, tracking error increases as sector bets increase.
The Effects of Beta on Tracking Error
Tracking Error
40%
Probability of Shortfall
35%
30%
25%
20%
15%
10%
5%
0%
0% 5% 10% 15% 20% 25%
Tracking Error
Note: 1) Dramatic shortfall is assumed to be a shortfall of 10% or more. 2) Portfolio excess returns
w ere assumed to be normally distributed. 3) Portfolio alpha w as set at -0.93%. During the 15 years
ended Sept 2002, the median active domestic large cap stock fund had an annalized return that w as
0.93% low er than that of the S&P 500 over that period, according to Morningstar.
Appendix
Tracking Error of Enhanced Index Fund
rp = wi*ri + wa*ra
Var ( rp - rb ) = Var {wi*(ri - rb)} + Var {wa*(ra - rb)} + 2*wi*wa*Corr(ri - rb, ra - rb)*std(ri - rb)* std(ra - rb)
rp = *rb + e
rp - rb = (-1)*rb + e
There would be no correlation between rb and the error term due to the regression.
Tracking error and beta
rp - rm = (w-1)*rm = (-1)*rm