Financial Risk Manager Part 1

In portfolio management, the tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. The smaller the tracking error, the closer the portfolio is following the benchmark. Therefore, the tracking error should be kept below a stated threshold to ensure that the portfolio's performance does not deviate significantly from the benchmark. On the other hand, transaction costs refer to the costs incurred when buying or selling securities. These costs can significantly impact the portfolio's returns, especially in the case of frequent trading. Therefore, it is crucial for the manager to minimize these costs to maximize the portfolio's net returns.

Choice B is incorrect. While it is true that transaction costs should be minimized, the tracking error should not be kept above a specified threshold. The tracking error measures the deviation of the portfolio return from the benchmark return, and keeping it below a certain limit ensures that the portfolio does not deviate too much from its benchmark.

Choice C is incorrect. Although it would be ideal to eliminate transaction costs entirely, this is often not feasible in practice due to various factors such as brokerage fees, bid-ask spreads etc. Therefore, while efforts should be made to reduce these costs as much as possible, they cannot typically be completely eliminated. Furthermore, similar to choice B, tracking error should ideally be kept below a specified threshold.

Choice D is incorrect. This option contradicts both principles of effective portfolio management mentioned in the question - tracking error should ideally be kept below (not above) a specified threshold and transaction costs need to minimized (not maximized). Maximizing transaction costs would lead to lower net returns for investors which goes against basic principles of investment management.