Tracking Error

What Is Tracking Error?

Tracking error measures how closely an investment portfolio follows its benchmark. A benchmark is a reference index, such as a broad stock market index, that a fund aims to match or beat. Tracking error captures the gap between the two. A fund that moves almost exactly in step with its index has a low tracking error, while a fund that often takes different positions or returns from its index has a high one.

How It Is Calculated

Tracking error is typically found by taking the difference between the portfolio's return and the benchmark's return for each period, such as each month or each day, and then measuring how much those differences vary. In simple terms, it is the standard deviation of these return differences, often annualized so that figures from different time frames can be compared.

Tracking error = standard deviation of (portfolio return minus benchmark return)

Why It Matters to Investors

Tracking error helps investors understand how a fund behaves relative to the market it is meant to represent. Index funds, which are designed to replicate an index, are generally expected to have very low tracking error. Actively managed funds usually have higher tracking error, because their managers deliberately hold different securities or weightings in pursuit of extra returns. Neither level is inherently good or bad. A higher figure simply means the fund's results are likely to differ more from its benchmark, in either direction.

Tracking error is also tied to the concept of active risk, sometimes called tracking risk. It is distinct from the total risk of an investment, which measures how much the investment's own returns fluctuate.

Factors That Influence Tracking Error

Several factors can cause tracking error. Fees and expenses reduce returns, so a fund's returns can trail its benchmark even when it holds the same securities. Cash held in the fund, the timing of dividend payments, and the cost of buying and selling securities can also create gaps. When a fund uses sampling rather than holding every security in an index, its tracking error may rise as well.

Investors often compare the tracking difference of a fund alongside its tracking error. Tracking difference shows the average gap in returns over time, while tracking error shows how consistent that gap is. Reviewing both gives a fuller picture of how a fund has followed its benchmark.