Financial Risk Manager Part 1

Explanation

When evaluating portfolio managers' stock-picking skills, tracking error is a key metric to consider. Tracking error measures the standard deviation of the difference between a portfolio's returns and its benchmark returns.

Key Points:

• Tracking Error Definition: Tracking error = σ(Rp - Rb), where Rp is portfolio return and Rb is benchmark return
• Stock-Picking Skills: Good stock-picking skills should result in portfolio returns that closely track the benchmark while achieving superior performance
• Low Tracking Error: Indicates the portfolio manager is effectively replicating the benchmark while making selective deviations for alpha generation
• High Tracking Error: Suggests the portfolio is significantly deviating from the benchmark, which could be due to poor stock selection or excessive risk-taking

Why Option B is Correct:

Since all portfolios have the same level of risk as the benchmark, the manager with the lowest tracking error demonstrates the most precise stock-picking skills. This means they can achieve their investment objectives while maintaining close alignment with the benchmark, indicating superior security selection abilities.

Why Other Options are Incorrect:

• A: High tracking error suggests excessive deviation from the benchmark, not necessarily good stock-picking
• C: Low information ratio indicates poor risk-adjusted excess returns relative to tracking error
• D: Sharpe ratio measures total risk-adjusted returns, not specifically stock-picking skills relative to a benchmark

Therefore, the manager with the lowest tracking error demonstrates the most refined stock-picking skills while maintaining benchmark-like risk characteristics.