Addressing Tracking Error in Passive Equity Investing

Investors often evaluate portfolio performance through various metrics, one of which is tracking error. Tracking error measures the volatility of the difference between a portfolio's returns and the benchmark index it aims to replicate. This metric is crucial for passive equity managers, as it indicates how closely their fund is following the benchmark. A lower tracking error suggests greater consistency with the benchmark returns, while a higher tracking error indicates more deviation.

Considering this, a large pension fund establishes a passive equity fund that aims to track the S&P 500 Index. Over time, the fund manager notices that the tracking error for the fund has increased significantly due to factors such as cash flows, transaction costs, and differences in portfolio holdings. The fund aims for a low tracking error, ideally below 1%.

After reviewing the situation, the fund manager needs to address the increase in tracking error to maintain the fund's objective of closely tracking the index.