Tracking Error aka The Error of Tracking


Aptly named, it is an error to start portfolio construction with the concept of how much one should deviate from an index.  The premise that an index should be a portfolio construction tool at all is flawed.  Yes, it may reflect the wider opportunity set in any market but that makes it at best, a reference point.  As for market capitalisation indices, why should I care what weight a stock is as part of an index?  Surely they should be equally weighted?

Readers of our thought pieces will be familiar with our views on such terms as tracking error and ‘active share’ which relate to deviations from indices. This latest piece stems from recently reading another in the regular output in the media of active versus passive investment management.  As one commentator noted; shouldn’t it be active and passive – you don’t have to choose one or the other, you can have both if you want.

Should we care about these labels at all? We like plenty of tracking error and active share because we, like the managers we select are index agnostic. Not constrained by being too big, they buy stocks they like and as one of our managers quoted back to us last week, if we don’t like it, we don’t own it. Simple, portfolios built from the bottom up not the index down.

This week, we’ve counted at least three articles in industry publications almost bludgeoning the public into focusing only on costs, tracking error and active share. These are the problems faced by large public pension funds with many billions to invest.  As we’ve said before, more than once, if you don’t have a billion or two to invest, why burden yourself with just those issues.  It was therefore with some surprise that I read a supposed champion of the smaller investor, Merryn Somerset Webb, state in last weekend’s FT Money that ‘you don’t get what you pay for’ when it comes to active managers.

Size Really Matters

Much of the debate around active versus passive, the measurement of tracking error and active share is by very large fund management groups and very large institutional investors who have so much money to deploy they invariably have to start with indices usually based on geography or at least that’s what their consultants might recommend. Interesting that in a world where cost is much to the fore that an extra layer of fees from a consultant almost slips under the radar. Are we to believe that investors out there have the skill to devise their own asset allocation and then populate it with individual equities or the best managers?

Some, yes, but the majority?


We believe that investors seek relevant investment outcomes that fit their investment objectives. They probably want to limit the downside to the portfolio’s performance while making sure their hard-earned wealth is preserved not in nominal terms but in relation to inflation – a potential eroder of wealth.
At least multi-asset funds have shone a light on scalable investment solutions based on an outcome not an index but much of the investment industry is caught in a time warp that favours input-based investing by asset class and geography. As we have noted before, if you are not a £multi-billion investor, pension fund or asset manager, you do not need to hinder yourself with their problems of too much size.

To Conclude

  • Ignore indices as part of a portfolio construction mechanism.
  • Focus on what you want your investment portfolio to achieve.
  • Find managers who;
    • talk about outcomes not tracking error & active share
    • build portfolios from the bottom up
    • have conviction in what they own and knows why

And you’ll probably find that you do get what you pay for – someone (like ourselves) that after fees, delivers a relevant and understandable investment outcome.

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