Active Risk
The standard deviation of the difference between a portfolio's returns and its benchmark returns, also called tracking error.
What is Active Risk?
Active risk, commonly called tracking error, measures the volatility of a portfolio's excess returns relative to its benchmark index. It is calculated as the standard deviation of the return difference (active return) between the portfolio and benchmark over a given period. Active risk quantifies how much a portfolio's performance deviates from its benchmark — a tracking error of 5% means the portfolio's returns typically differ from the benchmark by about 5 percentage points per year. Low active risk (near zero) indicates a portfolio that closely hugs its benchmark, characteristic of passive or index funds. High active risk indicates concentrated active bets. The information ratio — active return divided by active risk — measures how efficiently the manager generates alpha per unit of active risk taken. Regulators, pension trustees, and institutional clients often impose limits on permissible active risk levels.
Example
An active equity fund benchmarked to the S&P 500 has generated average annual active returns of +1.5% with an active risk (tracking error) of 6%. Its information ratio is 0.25 (1.5 / 6), suggesting modest risk-adjusted outperformance. A passive S&P 500 index fund, by contrast, has a tracking error of less than 0.05% — it replicates the benchmark almost perfectly.
Source: CFA Institute — Fixed Income and Equity Portfolio Management