High tracking error vital for downturn protection

Using historical data from the “two largest market drawdowns in the last five years”, an SSGA report highlighted that actively managed funds with low tracking error levels provided very little cushioning for returns.

“The only way the drawdown can be meaningfully reduced is without tracking error constraining the ability to position the fund differently from the benchmark,” the report said.

It argued that for an actively managed fund to minimise the impact of sharp negative returns in the equity market, the fund “really needs to be active”.

State Street Global Advisors' head of active quantitative equity for Asia-Pacific, Olivia Engel, told InvestorDaily that constraints on tracking error limit investors’ capability to outperform the benchmark.

“If you think you can generate a return that’s much different from the market, if that’s what you want, then having constraints on tracking error won’t enable you to achieve that,” she said.

Using data from Morningstar, the SSGA report highlighted that funds which significantly reduced the impact of the market drawdown had a higher average level of tracking error.

“Compared with the broader market return, meaningfully lower absolute risk, cushioning from severe market drawdowns and smoother absolute returns cannot be achieved in a fully invested equity portfolio with low tracking error,” the report said.

Ms Engel added that investors who are concerned about protecting capital from market volatility could benefit from fewer constraints.

“You need to free up your active fund to be able to do things that are different to the market for that downside risk protection,” she said.

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