Tracking error volatility and relative risk budgets

Abstract

This paper uses a pooled cross-sectional sample of actively managed US equity mutual funds from 1991–2022 to show that tracking error volatility (TEV) is characterised by reversion. Mutual funds with relatively high (low) TEV tend to reduce (increase) their TEV in subsequent periods, and the degree of reversion is determined by the degree to which TEV is relatively high or low. This suggests that TEV is managed over time to satisfy relative risk budgets. This paper also shows that the previous literature’s finding that mutual funds increase their TEV as their performance declines holds even when taking into consideration that both performance and change in TEV may be jointly determined by TEV level. The results are robust to a variety of measurement periods and methodologies.