Equity Valuation and Portfolio Management

FORWARD-LOOKING VS. BACKWARD-LOOKING TRACKING ERROR

In Exhibit 10.1 the tracking error of the hypothetical portfolio is shown based on the active returns reported. However, the performance shown is the result of the portfolio manager's decisions during those 30 weeks with respect to portfolio positioning issues such as beta, sector allocations, style tilt (that is, value versus growth), stock selections, and the like. Hence, we can call the tracking error calculated from these trailing active returns a backward-looking tracking error. It is also called the ex post tracking error.

One problem with a backward-looking tracking error is that it does not reflect the effect of current decisions by the portfolio manager on the future active returns and hence the future tracking error that may be realized. If, for example, the manager significantly changes the portfolio beta or sector allocations today, then the backward-looking tracking error that is calculated using data from prior periods would not accurately reflect the current portfolio risks going forward. That is, the backward-looking tracking error will have little predictive value and can be misleading regarding portfolio risks going forward.

The portfolio manager needs a forward-looking estimate of tracking error to accurately reflect the portfolio risk going forward. The way this is done in practice is by using the services of a commercial vendor that has a model, called a multifactor risk model, that has defined the risks associated ...