The U.S. stock market’s rally rolled on for the trading week through December 22. The S&P 500 Index rose 0.8%, marking the eighth consecutive weekly gain, which lifted the benchmark ever closer to a record high.
The bond market continued to rally too, fueled by another week of declines in U.S. Treasury yields (bond prices and yields move inversely). The 10-year yield, for instance, ticked down slightly to 3.90%, the lowest weekly close since mid-July.
With the start of a new year upon us, I imagine you will be looking to see how your portfolio’s performance compares to its benchmark. When doing so, it is important to keep in mind the concept of tracking error, one of the most important analytical tools in portfolio management.
Briefly, tracking error is a measurement of the extent to which the returns of a portfolio deviate from its benchmark index over a specific time period.
A low degree of tracking error is preferred when investing in fund that tracks an index, such as the S&P 500, because the goal is to closely mirror the benchmark's performance. By comparison, with an actively managed portfolio a higher tracking error is to be expected because in that case the goal is to outperform the benchmark by either generating higher returns, lessening risk, or both.
Risk-managed portfolios can experience an unusually high degree of tracking error when market risks are high, and the risks being guarded against fail to materialize. Such was the case in 2023, when the stock market was threatened by persistent inflation, rising interest rates, recession fears, turmoil in the banking sector, deadlock in Washington, and wars in Ukraine and Gaza. Much to the surprise of many market observers, Mr. Market managed to dodge all these threats, largely because of the extremely high gains posted by a small number of very large growth stocks. As a result, this time around risk management was a drag on the performance of risk-managed portfolios.
In short, tracking error can be thought of as one way to measure the benefits and costs of risk management. With sound investment strategies, negative tracking error is expected to be short-lived, which is why longer time frames are preferred when assessing a strategy’s vulnerability to tracking error.
That’s all for now. Happy holidays and invest wisely my friends.