Actively managing tracking error

Managing tracking error on an ex ante basis requires an ability to assess the possible effects of trades on a fund's performance relative to its benchmark. This paper develops several simple diagnostic tools to help fund managers evaluate alternative trading strategies in terms of their potential for reducing tracking error. Moreover, risk reductions can be readily balanced against trading requirements and impacts on active return to identify desirable strategies. The methodology described in this paper can be extended in several ways. For example, it is straightforward to incorporate simple trading restrictions, such as preventing short positions, in the analysis. In this case, the trade risk profile is truncated to reflect only those portfolios that are acceptable. Alternatively, it is possible to construct a profile showing an asset's tracking error contribution as a function of the trade size.