Tracking Error Volatility Formula Excel:A Guide to Calculating and Understanding Tracking Error Volatility in Mutual Funds

cullensauthor2023/11/28 16:19:57

Tracking Error Volatility Formula in Excel: A Guide to Calculating and Understanding Tracking Error Volatility in Mutual Funds

Tracking error volatility (TEV) is a measure of the volatility of a mutual fund's performance relative to a benchmark index. It provides investors with insights into the fund's potential risk-adjusted performance and helps them make more informed investment decisions. Calculating TEV and understanding its implications for mutual funds is crucial for investors, portfolio managers, and fund managers alike. This article provides a step-by-step guide to calculating TEV in Excel and discusses the importance of understanding TEV in portfolio management.

Calculating Tracking Error Volatility in Excel

1. Prepare the data: First, gather the performance data for the fund and the benchmark index over a suitable time period, such as one year. The fund's performance should be compared to the benchmark index's performance.

2. Calculate the portfolio returns: Calculate the monthly returns for the fund and the benchmark index over the time period.

3. Calculate the monthly correlation coefficient: Calculate the monthly correlation coefficient between the fund's performance and the benchmark index's performance. This can be done using the Pearson correlation coefficient or the Spearman rank correlation coefficient, depending on the data type.

4. Calculate the portfolio standard deviation: Calculate the monthly portfolio standard deviation using the portfolio returns and the corresponding monthly returns for the benchmark index.

5. Calculate the tracking error: Calculate the tracking error using the formula TEV =

(1 - correlation) * portfolio standard deviation

.

6. Calculate the average tracking error: Calculate the average tracking error over the time period by dividing the total tracking error by the number of months in the time period.

7. Calculate the annualized tracking error: Calculate the annualized tracking error by multiplying the average tracking error by the annualized rate of return for the benchmark index.

Understanding Tracking Error Volatility in Portfolio Management

Tracking error volatility provides valuable insights into a fund's risk-adjusted performance and helps investors make more informed decisions. By understanding TEV, investors can:

1. Evaluate the fund's risk-adjusted performance: TEV provides a measure of the fund's risk-adjusted performance relative to the benchmark index. High TEV indicates that the fund's performance is more volatile than the benchmark index, while low TEV indicates that the fund's performance is less volatile.

2. Evaluate the fund's risk profile: TEV helps investors evaluate the fund's risk profile by providing a measure of the volatility of the fund's performance relative to the benchmark index.

3. Compare funds: By understanding TEV, investors can compare the risk-adjusted performance of different funds and make more informed investment decisions.

4. Implement portfolio rebalancing strategies: Understanding TEV can help investors implement portfolio rebalancing strategies to manage risk and improve the fund's risk-adjusted performance.

Tracking error volatility is a crucial measure for understanding the risk-adjusted performance of mutual funds and making informed investment decisions. Calculating TEV in Excel is a simple and effective way to evaluate the risk-adjusted performance of funds and compare them to one another. By understanding TEV, investors can make more informed decisions and improve their portfolio's risk-adjusted performance.