Understanding Tracking Error in Passive Equity Investing

Very Hard Passive Equity Investing Tracking Error

John, a portfolio manager at a large institutional investment firm, oversees a passive equity fund designed to replicate the performance of the S&P 500 Index. Over the past year, he has noticed that the fund's returns have deviated from the index returns, resulting in a tracking error of 1.5%. Intrigued by this, he gathers his team to analyze the reasons for this discrepancy and consider strategies for minimizing tracking error without sacrificing the passive investment approach.

Tracking error is a critical measure for passive funds since it quantifies the degree to which the fund’s performance diverges from its benchmark. These deviations can arise from various factors, including management fees, replication techniques, or the liquidity of component stocks. In this context, determine the statement regarding tracking error that is most accurate.

Tracking error can be reduced by investing in highly liquid stocks that closely match the weightings of the benchmark.

A larger tracking error typically indicates that the active management strategy of the fund is succeeding.

Tracking error is irrelevant for passive funds as long as they achieve close to their target return.

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