Managing Tracking Error in Passive Equity Investing

As a portfolio manager of a passive equity fund that aims to mirror the performance of the S&P 500 Index, you are tasked with managing tracking error effectively. The fund has recently had a tracking error of 150 basis points (bps) relative to its benchmark. A client expresses concern over this amount, citing its potential negative implications on investment performance and client retention. Your response should analyze the concept of tracking error, explain the factors that might contribute to it, and demonstrate strategies to manage or reduce tracking error while still meeting the fund's objective of passive management. Additionally, discuss how tracking error interacts with the concepts of capital markets expectations and risk management.