Tracking error

Tracking error is the standard deviation of the difference between a fund’s returns and its benchmark’s returns, usually calculated from daily, weekly or monthly data and expressed as an annual figure. If a fund lagged its index by exactly the same amount every period, its tracking error would be zero, even though it underperformed. A high tracking error means the fund’s returns wander around the index’s unpredictably. Causes include sampling (holding only some of the index’s securities), cash flows in and out, the timing of dividend payments and, for synthetic funds, the terms of their swaps.

For an index fund, a low tracking error is a sign of careful management. For an active fund, tracking error measures how different the manager’s portfolio is from the benchmark: a fund that claims to be active but has a very low tracking error may be a ‘closet tracker’, charging active fees for index-like returns. The term is often used loosely to mean the average gap between fund and index, which is properly called tracking difference. The two answer different questions: how far behind, and how erratically.