Using Tracking Error to Guide Client Expectations
Aperio Group Three Harbor Drive, Suite 315 Sausalito, CA 94965 (415) 339-4300 www.aperiogroup.com Photo: Martin Teasdale, Kiwirail
Aperio v. [Latin] to make clear, to reveal the truth
Copyright © 2015 Aperio Group LLC
Overview • What Is Tracking Error? • Using Tracking Error to Guide Client Expectations • Projected vs. Realized Tracking Error • Volatility and Tracking Error • Summary
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What Is Tracking Error?
What Is Tracking Error? • The distance between a portfolio and its benchmark • A measure of how effectively a portfolio’s returns mimic the returns of its benchmark • A unifying framework that can be used • Across portfolios • In different market conditions • Over time
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Benchmark Returns Are a Moving Target Market Returns Vary Greatly Over Time Russell 3000 Index Annual Total Returns 1998 - 2014 40% Russell 3000 Annual Returns 30% 20% 10% 0% -10% -20% -30% -40% '88
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Data Source: Frank Russell data via Bloomberg
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Benchmark Returns Are a Moving Target Volatility returns is similar to volatility of an index-tracking portfolio Portfolio Volatility of ofan anindex Index’s Returns Is Similar to the Volatility of an Index-Tracking Russell 3000 Annual Total Returns & Aperio US Carbon-Divested Index Tracking Portfolio Portfolio Returns Returns Russell 3000Index Index Annual Total Returns & Aperio US Carbon-Divested Index Tracking 40%
Russell 3000 Annual Returns US Carbon-Divested Index Tracker
30% 20% 10% 0% -10% -20% -30% -40% '88
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Data Source: Frank Russell data via Bloomberg; Aperio Group
The Aperio US Carbon-Divested Index Tracking Portfolio is a US market strategy that seeks to match the performance of the Russell 3000 Index while excluding companies involved in the extraction and production of oil, gas, or coal. The results presented in this chart are based on hypothetical analysis techniques (also known as back-testing) and are not actual portfolios. Past performance is not a guarantee of future returns. Please refer to important disclosures at the end of this presentation.
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Yet Tracking a Benchmark Is Compatible with a Wide Range of Investment Goals Tracking Volatility of of anan Index TrackingError ErrorisIsMuch MuchLess LessVolatile Volatilethan thanthe the Volatility Index Aperio US Carbon-Divested Carbon-DivestedIndex IndexTracking TrackingPortfolio's Portfolio'sRelative RelativeReturns Returns 40%
Index-Tracking Relative Return
30% 20% 10% 0% -10% -20% -30% -40% '88
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Data Source: Aperio Group
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Using Tracking Error to Guide Client Expectations
Portfolio Return and Tracking Error • Portfolio return has usually been in the range of the benchmark return +/- 2 TE –2 TE
–1 TE
Benchmark Return
+1 TE
+2 TE
• History provides a detailed picture of how portfolio returns have lined up with tracking error projections • We’ll look at the historical frequency of different return/TE outcomes • Greater tracking error means lower fidelity of a portfolio to its benchmark 9
Guiding Questions About Portfolio Return and Tracking Error • How often is my portfolio return … • … in the range of benchmark return +/- 1 TE? • … less than benchmark return – 2 TE? • These questions do not depend on the value of TE • The answers to these questions can be used to guide client expectations
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Guiding Client Expectations: a 90bp Example • Historical experience: Roughly 66% of the time, Aperio portfolio returns have been within 1 TE of the benchmark return • Example: TE = 0.90% • Expect that 66% of the time, the portfolio return will be in the range of the benchmark return +/- 0.90% -0.90% –2 TE
–1 TE
+0.90% Benchmark Return
+1 TE
+2 TE
66% of time
• Is your client comfortable with that? 11
Guiding Client Expectations: a 90bp Example • Historical experience: Roughly 90% of the time, Aperio portfolio returns have been within 2 TE of benchmark returns • Example: TE = 0.90% • Expect that 90% of the time, the portfolio return will be in the range of the benchmark return +/- 1.80% -1.80% –2 TE
+1.80% –1 TE
Benchmark Return
+1 TE
+2 TE
90% of time
• Is your client comfortable with that? 12
Guiding Client Expectations: a 90bp Example • Historical experience: Roughly 10% of the time, Aperio portfolio returns have been outside a 2 TE range of benchmark returns • Example: TE = 0.90% • Expect that 10% of the time, the portfolio return will be greater than the benchmark return +1.80% • …or less than the benchmark return -1.80% -1.80% –2 TE
+1.80% –1 TE
Benchmark Return
+1 TE
+2 TE
10% of time
• Is your client comfortable with that? 13
Performance Is Colored by Tracking Error Projections Frequency 35% 30% 25% 20%
Rhonda Risktaker
15% 10% 5% 0% < -2 TE
-12%
-7%
-2%
[-1 TE, 0]
3%
[0, 1 TE]
8%
13%
[1 TE, 2 TE]
18%
> 2 TE
23%
28%
P
–4 TE –3 TE –2 TE –1 TE
Benchmark Performance
Tracking Error = 5% Benchmark = 8% Portfolio = 4%
[-2 TE, -1 TE]
+1 TE +2 TE +3 TE +4 TE
Source: Aperio Group. Histogram values calculated from 76,280 monthly returns divided by beginning-of-month Projected Tracking Error (“monthly-ized”) across all open and closed Aperio accounts for all historical time periods. Past performance is not a guarantee of future returns. Returns are relative to the portfolio benchmarks and are gross of fees and transaction costs. Please refer to important disclosures at the end of this presentation.
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Performance Is Colored by Tracking Error Projections Frequency 35% 30% 25% 20%
Charlie Conservative
15% 10% 5% 0% < -2 TE
4%
5%
6%
[-1 TE, 0]
7%
[0, 1 TE]
8%
9%
[1 TE, 2 TE]
10%
> 2 TE
11%
12%
P
–4 TE –3 TE –2 TE –1 TE
Benchmark Performance
Tracking Error = 1% Benchmark = 8% Portfolio = 4%
[-2 TE, -1 TE]
+1 TE +2 TE +3 TE +4 TE
Source: Aperio Group. Histogram values calculated from 76,280 monthly returns divided by beginning-of-month Projected Tracking Error (“monthly-ized”) across all open and closed Aperio accounts for all historical time periods. Past performance is not a guarantee of future returns. Returns are relative to the portfolio benchmarks and are gross of fees and transaction costs. Please refer to important disclosures at the end of this presentation.
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Expectations Must Be Tailored to Horizon • Tracking error is quoted as “annualized percent" • Over different horizons, the quoted range scales by the square root of time
Source: Aperio Group
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Expectations Must Be Tailored to Horizon • Tracking error is quoted as “annualized percent" • Over different horizons, the quoted range scales by the square root of time
Source: Aperio Group
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Projected vs. Realized Tracking Error
Projected vs. Realized Tracking Error • Projected tracking error • Used to construct portfolios • Generated by a factor model and tuned to the contemporaneous volatility regime • Realized tracking error • Used to evaluate performance • Averaged across volatility regimes
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Projected vs. Realized Tracking Error Monthly Active Returns 1.00% 0.75% 0.50% 0.25% 0.00% -0.25% -0.50% -0.75% -1.00% '08
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Source: Aperio Group. Portfolio holdings and characteristics have been calculated using a large-cap tax-loss harvesting model portfolio. Client accounts may vary. Returns are relative to the portfolio benchmark, which is the S&P 500 Total Return Index, and are gross of fees and transaction costs. Past performance is not a guarantee of future returns. Please refer to important disclosures at the end of this presentation.
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Projected vs. Realized Tracking Error Monthly Active Returns are mostly between the bands of +/- 1 times Projected TE 1.00% Monthly Active Returns 0.75% Projected TE 0.50% 0.25% 0.00% -0.25% -0.50% -0.75% -1.00% '08
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Source: Aperio Group. Portfolio holdings and characteristics have been calculated using a large-cap tax-loss harvesting model portfolio. Client accounts may vary. Returns are relative to the portfolio benchmark, which is the S&P 500 Total Return Index, and are gross of fees and transaction costs. Past performance is not a guarantee of future returns. Please refer to important disclosures at the end of this presentation.
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Projected vs. Realized Tracking Error Monthly Active Returns are mostly between the bands of +/- 2 times Projected TE Monthly Active Returns with Projected TE bands 1.00% Monthly Active Returns 0.75% Projected TE 0.50% 0.25% 0.00% -0.25% -0.50% -0.75% -1.00% '08
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Source: Aperio Group. Portfolio holdings and characteristics have been calculated using a large-cap tax-loss harvesting model portfolio. Client accounts may vary. Returns are relative to the portfolio benchmark, which is the S&P 500 Total Return Index, and are gross of fees and transaction costs. Past performance is not a guarantee of future returns. Please refer to important disclosures at the end of this presentation.
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Projected vs. Realized Tracking Error Realized 12-Month Tracking Error May Differ from Projected Tracking Error Projected TE 1.75%
Projected TE
1.50%
1.25%
1.00%
0.75%
0.50%
0.25%
0.00% '08
'09
'10
'11
'12
'13
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Source: Aperio Group. Portfolio holdings and characteristics have been calculated using a large-cap tax-loss harvesting model portfolio. Client accounts may vary. Returns are relative to the portfolio benchmark, which is the S&P 500 Total Return Index, and are gross of fees and transaction costs. Past performance is not a guarantee of future returns. Please refer to important disclosures at the end of this presentation.
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Projected vs. Realized Tracking Error Realized 12-Month Tracking Error May Differ from Projected Tracking Error Projected TE versus next 12-month Realized TE lagged 12 months 1.75% Projected TE 1.50% Realized TE 1.25%
1.00%
0.75%
0.50%
0.25%
0.00% '08
'09
'10
'11
'12
'13
'14
'15
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Source: Aperio Group. Portfolio holdings and characteristics have been calculated using a large-cap tax-loss harvesting model portfolio. Client accounts may vary. Returns are relative to the portfolio benchmark, which is the S&P 500 Total Return Index, and are gross of fees and transaction costs. Past performance is not a guarantee of future returns. Please refer to important disclosures at the end of this presentation.
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Projected vs. Realized Tracking Error Monthly Active Returns are mostly between the bands of +/- 2 times Projected TE Monthly Active Returns with Projected TE bands 1.00% Monthly Active Returns 0.75% Projected TE 0.50% 0.25% 0.00% -0.25% -0.50% -0.75% -1.00% '08
'09
'10
'11
'12
'13
'14
'15
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Source: Aperio Group. Portfolio holdings and characteristics have been calculated using a large-cap tax-loss harvesting model portfolio. Client accounts may vary. Returns are relative to the portfolio benchmark, which is the S&P 500 Total Return Index, and are gross of fees and transaction costs. Past performance is not a guarantee of future returns. Please refer to important disclosures at the end of this presentation.
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Projected vs. Realized Tracking Error Realized 12-Month Tracking Error May Differ from Projected Tracking Error Projected TE versus next 12-month Realized TE lagged 12 months 1.75% Projected TE 1.50% Realized TE 1.25%
1.00%
0.75%
0.50%
0.25%
0.00% '08
'09
'10
'11
'12
'13
'14
'15
'16
Source: Aperio Group. Portfolio holdings and characteristics have been calculated using a large-cap tax-loss harvesting model portfolio. Client accounts may vary. Returns are relative to the portfolio benchmark, which is the S&P 500 Total Return Index, and are gross of fees and transaction costs. Past performance is not a guarantee of future returns. Please refer to important disclosures at the end of this presentation.
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Projected vs. Realized Tracking Error Monthly Active Returns are mostly between the bands of +/- 2 times Projected TE Monthly Active Returns with Projected TE bands 1.00% Monthly Active Returns 0.75% Projected TE 0.50% 0.25% 0.00% -0.25% -0.50% -0.75% -1.00% '08
'09
'10
'11
'12
'13
'14
'15
'16
Source: Aperio Group. Portfolio holdings and characteristics have been calculated using a large-cap tax-loss harvesting model portfolio. Client accounts may vary. Returns are relative to the portfolio benchmark, which is the S&P 500 Total Return Index, and are gross of fees and transaction costs. Past performance is not a guarantee of future returns. Please refer to important disclosures at the end of this presentation.
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Volatility and Tracking Error
Volatility and Tracking Error • There is more than one dimension to risk • Volatility measures portfolio risk • Tracking error measures the risk of a portfolio relative to its benchmark • Because benchmarks are risky, it is impossible for both volatility and tracking error to be small
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Volatility vs. Tracking Error Volatility
Tracking Error
What does it measure? Absolute portfolio risk
Portfolio risk relative to a benchmark
How is it used?
Understanding “the ride”
Understanding deviation from a benchmark
What does it tell you?
The range of typical returns
The range of typical differences in return between a portfolio and a benchmark
What can’t it do?
Guarantee outcomes
Guarantee outcomes
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Summary
Photo: Martin Teasdale, Kiwirail
Tracking Error • Measures the distance between a portfolio and a benchmark • Determines a range of typical outcomes for portfolio return relative to the return of the benchmark • Guides client expectations about a broad class of strategies • But it does not guarantee outcomes
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Tracking Error • Has two orientations: • Projected (or forward-looking): used for portfolio construction • Realized (or backward-looking): used for performance attribution • Is a counterpoint to volatility, which measures absolute portfolio risk
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Thank You
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Comments/Questions Call or Email: • Ken Lassner 646-554-4163
[email protected] • Rick Moreno 415-339-4293
[email protected]
© Conde Nast. Used by permission.
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Disclosures The information contained within presentation was carefully compiled from sources Aperio believes to be reliable, but we cannot guarantee accuracy. We provide this information with the understanding that we are not engaged in rendering legal, accounting, or tax services. In particular, none of the examples should be considered advice tailored to the needs of any specific investor. We recommend that all investors seek out the services of competent professionals in any of the aforementioned areas. With respect to the description of any investment strategies, simulations, or investment recommendations, we cannot provide any assurances that they will perform as expected and as described in our materials. Past performance is not indicative of future results. Every investment program has the potential for loss as well as gain. Some portfolio holdings and characteristics in this presentation have been calculated using model accounts. Client accounts may vary. Some performance figures are based on composites, which may deviate from the performance of any individual account due to the age of that account relative to the age of the cohort of accounts that comprise the composite. The Aperio composite performance returns are net of advisory fees and expenses and reflect the reinvestment of dividends and other income. The performance reflected in some tables and charts are hypothetical, shown for illustrative purposes only, and not based on actual investments. Furthermore, they do not reflect the deduction of any management fees or transaction costs, which would lower performance returns. The use of hypothetical performance has significant limitations, some of which are described below. Back-testing involves simulation of a quantitative investment model by applying all rules, thresholds, and strategies to a hypothetical portfolio during a specific market period and measuring the changes in value of the hypothetical portfolio based on the actual market prices of portfolio securities. Investors should be aware of the following: 1) Back-tested performance does not represent actual trading in an account and should not be interpreted as such, 2) back-tested performance does not reflect the impact that material economic and market factors might have had on the manager’s decision-making process if the manager were actually managing
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Disclosures (continued) client’s assets, and 3) there is no indication that the back-tested performance would have been achieved by a manager had the program been activated during the periods presented above. For back-tested performance comparisons, the benchmark returns are simulated using historical constituents’ weights and total returns. After-tax performance is an estimate based upon the highest U.S. Federal tax rate applicable at the time, currently 43.4% short-term, 23.8% long-term and 23.8% for dividends and other anticipated tax rates as specified by clients. Actual after-tax returns achieved may vary and could be lower than reported due to the investor's specific tax circumstances during the time period shown. Clients who do not pay the assumed tax rates, or those specified by the client or clients who do not have off-setting capital gains and income would not achieve the after-tax returns reported. Tax loss harvesting (taking losses purposely to offset current or future capital gains by this or other portfolios) plays a meaningful role to enhance after-tax returns. This strategy is most beneficial in periods of higher than normal market volatility and declining markets. The Russell 3000 Index measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market. The Russell 3000 Index is constructed to provide a comprehensive, unbiased, and stable barometer of the broad market and is completely reconstituted annually to ensure new and growing equities are reflected. The S&P 500 Total Return Index is an unmanaged group of equities representing the large-cap sector of the US domestic market. Index returns reflect reinvestment of dividends but do not reflect fees, brokerage commissions, or other expenses of investing. Tracking Error: A measure of how closely a portfolio tracks its benchmark. In technical language, tracking error is the standard deviation of the return difference between a portfolio and a benchmark.
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