Demystifying the Relationship between Trading-Level and Portfolio-Level Tracking Error

Abstract

This article describes the relationship between the tracking error (TE) of the underlying portfolio in a large asset transition and of the residuals to be traded. It demonstrates that the issue, properly phrased, is really “what is the relationship between two linear functions?” Though seemingly obvious mathematically-the relationship is linear-in practice, too much trader and portfolio manager time is lost because of the difficulty in seeing to the heart of the question. With proofs and examples, the authors hope to settle the question for practitioners, making clear the common point between the two perspectives.