Quantile Tracking Errors (QuTE)

Abstract

The tracking error is a ubiquitous tool among active and passive portfolio managers, used widely for fund selection, risk management, and manager compensation. In this paper, we show that traditional measures of tracking error are incapable of detecting variations in higher-order moments (e.g. skewness and kurtosis). As a solution, we introduce a new class of Quantile Tracking Errors (QuTE), which measures deviations in the quantile of return distributions between a tracking portfolio and its benchmark. Through an extensive simulation study, we show that QuTE can detect variations in higher-order moments. We also offer guidance on the granularity of the quantile grid and weighting schemes for the relative importance of various quantiles. A case study illustrates the benefits of QuTE during the Dot Com Bubble and the Great Recession.

Keywords: tracking error, index tracking, portfolio tracking, index fund, quantile

JEL Classification: G11