Evaluating Causes and Solutions for Tracking Error in Passive Equity Investing

As a portfolio manager at a passive equity investment firm, you are tasked with managing a large-cap U.S. equity index fund that aims to replicate the performance of the S&P 500 index. Your fund, however, has recorded a tracking error of 2.5% over the past three years relative to the benchmark.

You are required to evaluate the potential causes of the tracking error and suggest strategies for reducing it. Additionally, consider the implications of tracking error on investor perceptions and the management of client expectations regarding fund performance. In your analysis, include specific examples of how passive management can still encounter deviations from the benchmark and address the trade-off between tracking error and associated costs.