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When is tracking error not really an error? By Nick Kalivas, Senior Equity Product Strategist, Invesco PowerShares Traditional indexes were never intended to define what makes a sound investment opportunity, which has fueled the popularity of factor-based investing. But they do serve as useful benchmarks for investment performance. How closely a portfolio or index tracks a particular benchmark index is referred to as “tracking error.” Tracking error is often considered in the context of a portfolio relative to an underlying index. But tracking error can also exist between two indexes, which raises questions. Take, for example, the case of low volatility investing – one of the most popular investment factors in use today. Could the S&P 500 Low Volatility Index – a commonly used barometer of low volatility stock performance – result in too much tracking error relative to its parent index, the S&P 500 Index? Because the S&P 500 Low Volatility Index selects 100 stocks from its parent index with the lowest realized volatility over the previous year, the S&P 500 Low Volatility Index can have sector exposure that is materially underweight or overweight relative to the S&P 500 Index. Should this be a concern? That depends on your perspective. The relationships between tracking error and low volatility exposure The table below shows the impact of blending the S&P 500 Low Volatility Index with the S&P 500 Index over a five-year period. It reveals a number of informational nuggets. Relationship between low volatility exposure, tracking error and performance April 30, 2011, through March 31, 2016 Source: Bloomberg L.P., March 31, 2016. Past performance is no guarantee of future results. First off, note the correlation between factor tilt and performance. During this time period, investors who had more low volatility exposure realized higher absolute and risk-adjusted returns. By itself, an allocation to the S&P 500 Low Volatility Index outperformed the S&P 500 Index by 22.5% (13.60% to 11.10%), with 24.4% less volatility (9.30% to 12.30%) over the five-year period. The results are consistent with the low volatility anomaly, which states that low volatility stocks may outperform higher volatility stocks and the broader market on an absolute and risk-adjusted basis.1 Note that the return per unit of risk increases as the low volatility factor tilt increases (0.90 for a 100% S&P 500 Index allocation, for example, to 1.22 with a 50-50 blend). Also note the proportional correlation between allocation to the S&P 500 Low Volatility Index and tracking error. The chart below plots this relationship alongside risk-adjusted return. Source: Bloomberg L.P., March 31, 2016. Past performance is no guarantee of future results. As you can see, the relationship between low volatility factor exposure and tracking error is linear. Tracking error is relatively small when small amounts of low volatility are blended into the S&P 500 Index. A portfolio with a 30% weighting in low volatility stocks, for example, had less than a 2.50% tracking error to the S&P 500 Index; 50-50 blend produced 4% tracking error. Keep in mind, though, that risk-adjusted returns also improved with increased tracking error. What all of this implies is that investors and their advisors can mix and match according to their comfort level. Blending material amounts of the low volatility factor into a portfolio will likely lead to increased tracking error relative to the S&P 500 Index, but can also enhance the performance of a portfolio on both an absolute and risk adjusted basis. What’s your choice? Learn more about the PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA: SPLV ). Read more blogs by Nick Kalivas . Important information Correlation is the degree to which two investments have historically moved in relation to each other. Tracking error measures the divergence between price behavior of a portfolio and the price behavior of a benchmark. Volatility measures the standard deviation from a mean of historical prices of a security or portfolio over time. The S&P 500® Low Volatility Index consists of the 100 stocks from the S&P 500® Index with the lowest realized volatility over the past 12 months. An investment cannot be made into an index. Typically, security classifications used in calculating allocation tables are as of the last trading day of the previous month. There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund’s return may not match the return of the Underlying Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund. Investments focused in a particular industry or sector, such as the industrials sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments. The Fund is non-diversified and may experience greater volatility than a more diversified investment. There is no assurance that the Fund will provide low volatility. The Global Industry Classification Standard was developed by and is the exclusive property and a service mark of MSCI, Inc. and Standard & Poor’s. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (S&P) and Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (Dow Jones). These trademarks have been licensed for use by S&P Dow Jones Indices LLC. S&P® and Standard & Poor’s® are trademarks of S&P and Dow Jones® is a trademark of Dow Jones. These trademarks have been sublicensed for certain purposes by Invesco PowerShares Capital Management LLC (Invesco PowerShares). The Index is a product of S&P Dow Jones Indices LLC and/or its affiliates and has been licensed for use by Invesco PowerShares. The Fund is not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices LLC, Dow Jones, S&P or their respective affiliates and neither S&P Dow Jones Indices LLC, Dow Jones, S&P or their respective affiliates make any representation regarding the advisability of investing in such product(s). Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: This article was posted on the Invesco PowerShares’ blog by an Invesco PowerShares’ employee on April 21, 2016: http://www.blog.invesco.us.com/measuring-performance-vs-benchmark-low-volatility-factor Scalper1 News
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