Tracking Error
What Is Tracking Error?
Tracking error measures how closely an investment fund follows the performance of its benchmark index. It represents the difference between the fund’s returns and the benchmark’s returns over time.
Tracking error is commonly used to evaluate index funds and exchange-traded funds (ETFs).
Why It Matters
Investors expect index funds to replicate the performance of their benchmark indexes. A lower tracking error indicates that the fund is closely matching the benchmark.
Higher tracking error may suggest inefficiencies, higher fees, or differences in portfolio construction.
How Tracking Error Works
Tracking error is calculated using the standard deviation of the difference between a fund’s returns and the benchmark’s returns.
Factors that may contribute to tracking error include:
- management fees
- portfolio rebalancing
- trading costs
- cash holdings
Even well-managed index funds may have small tracking errors.
Example
An ETF designed to track the S&P 500 might produce returns slightly above or below the index due to operating expenses or portfolio adjustments.
Tracking Error vs Active Management
- Tracking error measures how closely a fund follows its benchmark.
- Active management intentionally deviates from the benchmark in pursuit of higher returns.
FAQs About Tracking Error
Is tracking error bad?
Not always. Small differences are normal.
Do index funds have tracking error?
Yes, but it is typically very small.
Why do ETFs sometimes outperform their benchmark slightly?
Efficient management or securities lending may offset expenses.
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