Tracking error
Standard deviation of your portfolio's return MINUS the benchmark's return. Low tracking error = closet indexer; high tracking error = genuinely different bets vs benchmark.
Tracking error is a measure of how closely a portfolio's performance mirrors that of a specific benchmark. Imagine you're following a friend who always buys the same brand of bread, but sometimes you prefer a different brand because it's on sale. If your choice of bread varies little from your friend's, your shopping basket is similar to theirs; if it varies a lot, your basket is quite different. This is similar to how tracking error works in investing.
In Nigeria, if you're tracking the performance of your investments against the Nigerian Stock Exchange (NGX) All-Share Index, a low tracking error means your investments are performing similarly to the overall market. For example, if the NGX All-Share Index goes up by 5%, and your portfolio also goes up by 5%, your tracking error is zero. However, if your portfolio goes up by 3% while the index goes up by 5%, your tracking error is 2%.
Tracking error can be influenced by various factors. One factor is the Central Bank of Nigeria's Monetary Policy Rate (MPR), currently at around 27.50%. High interest rates can lead to fluctuations in bond prices, affecting the performance of portfolios that include bonds. Another factor is the 10% withholding tax (WHT) on dividends, which can reduce the returns of equity investments. Also, the 10% Capital Gains Tax (CGT) on profits from the sale of securities can impact the overall returns of a portfolio.
Understanding tracking error is crucial for Nigerian investors. It helps you determine whether your investment strategy is closely aligned with the market or if it's taking a different path. If you're aiming to match the market's performance, a low tracking error is desirable. However, if you're making strategic bets that differ from the market, a higher tracking error might be expected and acceptable.
Why it matters: Knowing the tracking error of your portfolio can help you understand how well your investment strategy is performing relative to the market. It allows you to assess whether your investments are delivering the expected returns and whether your strategy is aligned with your financial goals. This knowledge can guide your decisions on whether to stay the course or make adjustments to your portfolio.