At a meeting between a portfolio manager and a prospective client, the portfolio manager stated that her firm's bond investment strategy is a conservative one

The portfolio manager told the prospective client that she constructs a portfolio with a forward-looking tracking error that is typically between 250 and 300 basis points of a client-specified bond index. Explain why you agree or disagree with the portfolio manager's statement that the portfolio strategy is a conservative one.

If the chosen benchmark is the desired norm, then greater deviation from the norm implies more risk taking, i.e., less conservative than claimed by the portfolio manager. Regardless, it appears the manager is pursuing an active strategy that involves risk taking. More details are given below.

First, one would expect a higher tracking error over a longer horizon. Let's assume the
forward-looking tracking error given in our problem (between 250 and 300 basis points of
a bond index) is an annual tracking error. Even for this longer horizon, 250 to 300 basis points represent a large tracking error (especially compared to a zero tracking error which would be obtained if one just mimicked the benchmark). However, the tracking error is also unique to the benchmark used. If an improper benchmark is used then the tracking error measure may not be too meaningful.

Second, the strategy is not passive. When a portfolio is constructed to have a forward-looking tracking error of zero, the manager has effectively designed the portfolio to replicate the performance of the benchmark. If the forward-looking tracking error is maintained for the entire investment period, the active return should be close to zero. Such a strategy—one with
a forward-looking tracking error of zero or very small—indicates that the manager is pursuing
a passive strategy relative to the benchmark index.

Third, when the forward-looking tracking error is large the manager is pursuing an active strategy. The larger the deviation from the chose benchmark, the larger the tracking error and thus greater risk taking can be inferred. Forward-looking tracking error indicates the degree of active portfolio management being pursued by a manager. Therefore, it is necessary to understand what factors (referred to as risk factors) affect the performance of a manager's benchmark index. The degree to which the manager constructs a portfolio that has exposure to the risk factors that is different from the risk factors that affect the benchmark determines the forward-looking tracking error.