As an investment manager for a large institutional investor, you are tasked with evaluating your passive equity portfolio constructed to track the performance of the S&P 500 Index. The portfolio has experienced a tracking error of 2% over the past year. Your client is concerned about the tracking error and asks for clarification on its significance, possible causes, and strategies to minimize it while maintaining a passive approach.
In your response, discuss the concept of tracking error, providing a clear definition and its importance in passive equity investing. Identify the potential reasons for the observed tracking error in the context of your portfolio and outline effective measures that can be implemented to reduce tracking error. Conclude your response with your recommendations to the client regarding their expectations for tracking error in a passive investment strategy.