Understanding Tracking Error in Passive Equity Investing

Given the increasing popularity of passive equity investing strategies, an understanding of tracking error is essential for portfolio managers. Tracking error is a measure of how closely a portfolio follows the benchmark index it aims to replicate. It is typically expressed as the standard deviation of the differences between the portfolio returns and benchmark returns. In this context, discuss the implications of tracking error for a passive equity portfolio manager. Include how tracking error influences investment decisions, risk assessment, and performance evaluation. Additionally, highlight the factors that can contribute to tracking error in a passive investment strategy.