Tracking Error

Intermediate

Tracking error is the standard deviation of the difference between a fund's returns and the returns of its benchmark, showing how closely the fund follows the benchmark.

Tracking error measures how consistently a fund's performance matches its benchmark over time. A low tracking error means the fund's returns stay close to the benchmark; a high one means they often differ, in either direction.

For example, an index fund designed to track a stock market index might have a tracking error of 0.1%, meaning its returns almost exactly match the index. An actively managed fund might have a tracking error of 5%, reflecting the manager's decisions to hold different investments from the benchmark.

For index funds, a low tracking error is a sign of good management, since the goal is to replicate the benchmark. Sources of tracking error include fees, cash holdings, sampling of index components and the timing of trades.

For active funds, tracking error shows how much risk the manager takes relative to the benchmark. A higher tracking error is not necessarily bad, but it should be rewarded with higher returns. The information ratio, which divides excess return by tracking error, measures whether it is.

Tracking error differs from tracking difference, which is simply the gap between fund and benchmark returns over a period.

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