Tracking Error Dynamics – Residual or Planned?

August 29, 2014

Robert A. Gillam, CFA Chief Investment Officer McKinley Capital Management, LLC
Gregory S. Samorajski, CFA Director of Investments McKinley Capital Management, LLC

Numerous recent articles have highlighted the fact that the tracking error of many actively managed portfolios has declined from the levels observed five to ten years ago1. For example, Figure 1 shows the realized (rolling 36 month) tracking error of a typical non-U.S. equity portfolio managed by McKinley Capital Management, LLC (“McKinley Capital”) against an MSCI ACWI-ex US benchmark. Following a low of about 3.5% at the end of 2007, measured tracking error spiked from early 2009 through the end of 2011 to almost 7%, and then declined to its current level near 4%. Is a change in tracking error, particularly a decline, a cause for concern for investors seeking excess returns (“Alpha”) from active management? The answer is not simple. The perception is that tracking error (standard deviation of Alpha) is a measure of Alpha risk. It is assumed that more return can only be earned through more risk and that lower tracking error is a recipe for lower Alpha.

FIGURE 1: Non-U.S. Core Growth Tracking Error Analysis, March 2005 – June 2014

1408 Tracking-01 Fig1

However, higher levels of expected alpha do not always go hand in hand with higher levels of tracking error. It is well known that an increase in market-wide volatility is a primary cause of increasing portfolio tracking error even without any change in investment strategy (see Figure 2). The more important consideration is how a portfolio manager uses tracking error when thinking about the risk/return trade-off during portfolio construction.

In some instances, a manager will seek to construct portfolios that have a constant level of tracking error. The target level of tracking error is then a portfolio construction decision variable. All other things being equal, a higher risk target theoretically leads to higher expected alpha. A manager might choose a tracking error target on the basis of best expected information ratio, best expected Sharpe ratio, or some other criteria. However, all other things are not equal. As market volatility changes, a manager targeting a constant level of tracking error is required to raise or lower active exposures to compensate. For such a manager, significant changes in tracking error might indicate a change in style and an observed decline in tracking error might signal less interest in assuming risk to earn Alpha.

FIGURE 2: Active Risk vs. Market Risk, Fixed Exposure Portfolio

1408 Tracking-02 Fig2

However, higher levels of expected alpha do not always go hand in hand with higher levels of tracking error. It is well known that an increase in market-wide volatility is a primary cause of increasing portfolio tracking error even without any change in investment strategy (see Figure 2). The more important consideration is how a portfolio manager uses tracking error when thinking about the risk/return trade-off during portfolio construction.

In some instances, a manager will seek to construct portfolios that have a constant level of tracking error. The target level of tracking error is then a portfolio construction decision variable. All other things being equal, a higher risk target theoretically leads to higher expected alpha. A manager might choose a tracking error target on the basis of best expected information ratio, best expected Sharpe ratio, or some other criteria. However, all other things are not equal. As market volatility changes, a manager targeting a constant level of tracking error is required to raise or lower active exposures to compensate. For such a manager, significant changes in tracking error might indicate a change in style and an observed decline in tracking error might signal less interest in assuming risk to earn Alpha.

Alternatively, some managers seek to maintain stable exposure to factor risk rather than seek to maintain a target level of tracking error. Other managers seek to maintain a stable risk return trade-off regardless of the level of market-wide volatility. For these managers, changing tracking error is a residual of the portfolio construction process and is not expected to relate to the level of Alpha. In volatile times, tracking error increases; while in stable times, tracking error declines. In either regime, the manager seeks stable exposure to its skill variables. Managers in these categories target  stable risk-return trade-off levels or stable levels of factor exposure with an eye towards best information ratios, best Sharpe ratios, or other criteria.

McKinley Capital’s process is implemented by constructing portfolios with a targeted and stable risk-return trade-off (sometimes referred to as lambda) and secondarily, by monitoring for stable (but not necessarily constant) exposure to its momentum and earnings acceleration factors. While tracking error for its non-U.S. portfolios averages 4% to 6%, the firm does not expect tracking error to be stable, nor does it believe forecasted tracking error is a measure of expected Alpha. Figure 1 is illustrative. Over the range of tracking error regimes, McKinley Capital has maintained stable exposure to both growth and momentum factors and has maintained a stable active share. For the firm, realized tracking error is a result of exogenous changes in market-wide volatility or correlation and not due to any changes in active exposure or investment strategy.

So, is lower tracking error, in and of itself, a cause for concern for those hoping to earn active returns? For managers like McKinley Capital, the answer is no. For example, in a recent study by Hermes Fund Managers(2), a negative relationship between Alpha and tracking error was documented over the 36 months ending December 2013. The same study also documented a positive relationship between the variables ending in 2007. The study shows that there is not a consistent or necessary relationship between tracking error and Alpha for all managers. Specifically, McKinley Capital’s expected Alpha does not depend on levels of tracking error. McKinley Capital’s stable factor exposures and active share demonstrate consistency of process. For example, McKinley Capital’s returns have been better the past few low tracking error years than in the high tracking error period between 2009 to late 2011.

A decision by McKinley Capital to seek higher tracking error would likely be fraught with difficulties and may achieve less than satisfactory results. The previously cited Axioma paper discusses those issues in detail. The paper argues that past a point, increases in tracking error are no longer possible through additional exposure in manager skill factors, but only possible by assuming risk in factors where no manager skill is claimed. In practice, McKinley Capital believes it could create higher tracking error portfolios by increasing its current risk return trade-off parameter (lambda) targets. Using such a process, the firm’s expected information ratio would likely soon begin to decay, even if expected excess return were to increase. This outcome might be acceptable for accounts controlling risk using other means – perhaps through manager diversification. However, eventually even the prospects for additional return would disappear as desirable factor exposure is filled and only non-intended exposure is available. McKinley Capital has studied these tradeoffs in detail and is prepared to discuss them with interested investors.

2 Geir Lode – Hermes Fund Managers, Forward-Looking Portfolio Construction and Best Execution, Centre Investor Education, Aug. 2014

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