Understanding and Managing Tracking Error in Passive Equity Investing

As a portfolio manager for a large institutional investor, you are tasked with constructing a passive equity portfolio that closely tracks the performance of the S&P 500 index. You need to ensure that the tracking error of the portfolio remains within an acceptable range to meet the client's investment objectives.

1. Define tracking error and explain its significance in the context of passive equity investing.

2. Discuss the potential sources of tracking error that can arise when managing a passive equity portfolio.

3. Provide strategies you might employ to minimize tracking error in your portfolio, while still adhering to the principles of passive investing.

4. Additionally, analyze how the investor’s expectations about tracking error could impact their overall portfolio strategy and decisions.

Your response should demonstrate a comprehensive understanding of tracking error in the context of passive equity investing, drawing on relevant concepts and frameworks.