What does the Tracking Error measure in relation to the Information Ratio?

The Tracking Error measures the standard deviation of the difference between the portfolio return and the benchmark return. This metric provides insight into how closely an investment portfolio follows its benchmark index. A smaller tracking error indicates that the portfolio closely follows the benchmark, whereas a larger tracking error suggests more significant deviation from it.

In relation to the Information Ratio, which is a measure used to evaluate the risk-adjusted performance of an investment strategy, tracking error plays a crucial role. The Information Ratio is calculated by taking the excess return of the portfolio over the benchmark and dividing it by the tracking error. A higher Information Ratio suggests that the portfolio has generated more excess return per unit of risk (as measured by tracking error), making it a valuable metric for assessing portfolio performance in relation to benchmarks.

Understanding tracking error is essential for investors and portfolio managers as it provides a quantitative measure of how active a management strategy is relative to its benchmark, and it helps in making informed decisions regarding the balance between risk and return.