Explanation

Tracking error is defined as the standard deviation of the differences between the portfolio return and the benchmark return over a specific period. This makes option C the correct answer.

Key Points:

• Tracking error measures how closely a portfolio follows its benchmark
• It quantifies the volatility of the portfolio's relative performance
• Mathematically: Tracking Error = σ(R_p - R_b) where:
  • R_p = portfolio return
  • R_b = benchmark return
  • σ = standard deviation

Why other options are incorrect:

• Option A: This describes the volatility of the benchmark itself, not the tracking error
• Option B: This would be the average excess return (alpha), not tracking error
• Option D: This refers to differences between performance measures, not tracking error

Tracking error is particularly important for passive investment strategies where the goal is to closely replicate benchmark performance with minimal deviation.