I taught our Introduction to Performance Measurement course yesterday and one student asked how one might know whether, if the tracking error is high, it is because of (a) active management or (b) the wrong index being used?

I don’t believe there’s a simple way of knowing this. If the tracking error is exceptionally high (e.g., 15%), then the manger either obliterated the index or is doing something entirely different. So perhaps some levels make it clear that it’s probably the wrong index. Style analysis could be a tool that can be used to analyze the portfolio and see if it aligns with the index, at least to some extent. A review of the holdings, sectors, market caps may also be in order. If it’s a blended index, does the blend include all sectors in which the manager is investing?

We occasionally see managers use broad indexes, such as the S&P500, when their strategy involves a single style (e.g., growth) or market cap (e.g., mid cap). In this case, it’s pretty clear that we have the wrong index.

If you have ideas about this, please chime in. Thanks!