Liquidity refers to the ease with which an asset can be bought or sold in the market without significantly impacting its price. In this context, the investable indices are considered to offer better liquidity than the tracker portfolio.

Investable hedge fund indices are often constructed using liquid and widely traded assets or instruments. They are designed to be easily accessible and tradable for investors. On the other hand, the tracker portfolio may contain less liquid assets or strategies that are not as readily tradable.

When the tracker portfolio contains less liquid assets, it can be more challenging to buy or sell those assets in the market without impacting their prices. This can lead to higher transaction costs, slippage, or delays in executing trades, which can negatively impact the portfolio’s performance compared to the more liquid investable indices.

As a result, the tracker portfolio may experience a positive tracking error, indicating that it underperforms the investable index due to liquidity-related issues.

Things to Remember

• Tracking error is a measure of how closely a portfolio follows the index it is benchmarked against.
• Liquidity risk is the risk that an asset cannot be sold on short notice without incurring a loss.
• Operational costs include expenses such as trading costs, management fees, and administrative expenses.
• Investable hedge fund indices are designed to be replicable and investable by investors.
• Tracker portfolios aim to replicate the performance of a specific index or benchmark.