Correct Use of Ex-Ante Tracking Error in Portfolio Management

Abstract

We review the concept of ex-ante tracking error measurement in portfolio management, providing correct definition with respect to time projection of underlying factors. We emphasize the difference between the process of time projection and portfolio aggregation of returns as well as the conceptual difference between ex-ante and ex-post tracking error. The ex-ante tracking error is defined in terms of risk exposures of investment portfolio. Decomposition of analyzed risk measure is provided. Simple example shows calculation of ex-ante tracking error for the investment portfolio that tracks world equity indexes and partially hedges foreign currency exposure.

Keywords: ex-ante tracking error, compounded returns, risk exposures

JEL Classification: C10, G11