Definition
Tracking error measures how closely a portfolio follows its benchmark, calculated as the standard deviation of return differences between the portfolio and benchmark. Low tracking error indicates the portfolio closely mirrors the benchmark. High tracking error suggests significant deviation from the benchmark. Index funds aim for near-zero tracking error, while active managers accept higher tracking error in pursuit of outperformance. Tracking error is a key metric for evaluating index funds and understanding active risk.
Formula
Example
An S&P 500 index fund with 0.1% tracking error closely follows the index. An active large-cap fund with 4% tracking error makes significant bets different from the benchmark - more risk of underperforming but also potential for outperformance.
FAQ
What is Tracking Error?
The standard deviation of differences between portfolio and benchmark returns.
How do you calculate Tracking Error?
A common formula for Tracking Error is: Tracking Error = Standard Deviation of (Portfolio Return - Benchmark Return)
Why is Tracking Error important?
Tracking Error helps investors evaluate portfolio management and make more informed decisions.
Related Terms
R-Squared
A statistical measure of how much a fund's movements can be explained by benchmark movements.
Alpha
The excess return of an investment relative to a benchmark index.
Benchmark
A standard against which investment performance is measured.
Active Management
Investment approach where managers select securities to beat a benchmark.