A portfolio with a low tracking error relative to its benchmark typically indicates what?

• A. It consistently outperforms the benchmark.
• B. It underperforms the benchmark.
• C. It has performance that closely tracks the benchmark.
• D. It has high risk relative to the benchmark.

Answer: (C)

Tracking error measures how far a portfolio’s returns deviate from its benchmark over time. When that deviation is small, the portfolio’s returns move in near lockstep with the benchmark, so its performance effectively follows the benchmark’s path. That’s why the best description is that the portfolio’s performance closely tracks the benchmark. It doesn’t necessarily mean it will beat the benchmark every period—it's about staying near it. If you were aiming to outperform, you’d typically accept higher tracking error because you’re intentionally deviating from the benchmark. Conversely, a larger tracking error means more divergence from the benchmark’s path.