The components of tracking error, interim trading and mutual fund performance

This study examines active management due to interim trading in mutual funds. We propose a novel and standardized measure to estimate active management within a quarter. This measure is based on the fund tracking error in relation to the behaviour of a synthetic portfolio emulating its initial weight structure. In implementing a factor pricing model, this measure is decomposed into two components related to fund intra-quarterly changes in systematic and idiosyncratic risks. Results show that funds experience low levels of active management within a quarter, mainly arising from the differences in fund and synthetic portfolio residuals. In addition, interim trading erodes fund performance in the short term. Nonetheless, a positive effect on traditional alphas arises in the mid-term, linked to strategic asset allocation decisions. The suggested measure and the reported evidence are of interest to help stakeholders to understand and evaluate the impact of unobservable managerial decisions.