Limiting the Downside—and the Role of the Tracking Error
Toward establishing a discipline of measuring and attaining limited downside potential, we propose looking at one of the most common gauges of volatility—the tracking error1—and putting it in perspective.
A portfolio’s tracking error is not an adequate measure of volatility, because it gives equal treatment to the positive and negative differences between a portfolio and its benchmark—even though the former are obviously desirable, whereas the latter are not. For example, a theoretical portfolio that managed to stay roughly flat during a severe downturn would be characterized by a large tracking error on the upside, much to investors’ benefit.
A Strategy for Limiting Downside Potential and Seeking to Achieve Returns
To reduce volatility throughout the emerging market cycle, we propose the following loss-mitigation strategy:
• Maintaining a low tracking error and high volatility in risk-on periods.
• Maintaining a high tracking error and low volatility in risk-off periods.
We also propose a multi-part framework for riding out emerging market gyrations and achieving above-market annualized returns—one that includes global macro analysis, establishing a risk budget, determining country-level risk and security selection.
- ^Tracking error is a commonly used metric to gauge how well an investment is performing. Tracking error shows an investment’s consistency versus a benchmark over a given period of time.
This material is for informational purposes only and is not intended to be investment advice, a recommendation, or to predict or depict the performance of any investment.
Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates or an expectation of rising interest rates in the near future, will cause the values of a fund’s investments to decline. When interest rates rise, bond prices generally fall, and a fund’s share price can fall. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, regulatory and geopolitical risks. Emerging and developing market investments may be especially volatile. Diversification does not guarantee profit or protect against loss.