What it means
Every fund that quotes a benchmark is implicitly promising a relationship with it, and tracking error puts a number on how tight that relationship is. It is a measure of consistency rather than performance, so it says nothing about whether the fund is ahead or behind.
The distinction between tracking error and average outperformance confuses many people. A fund that beats its index by exactly 1% every year has strong performance and almost zero tracking error, while a fund that swings from 6% ahead to 5% behind has a large tracking error even if the average is the same.
For index funds the figure is a quality measure, and investors expect it to be very small, typically well under 0.5% a year. Anything higher suggests the fund is failing at its only job, usually because of costs, cash holdings, or imperfect replication of the index.
For active funds the interpretation flips. A manager charging active fees while producing a tracking error of 1% is effectively running an index fund at a premium price, a situation often called closet indexing.
The calculation is normally run on monthly returns over three or five years and then scaled to an annual figure. Using too few observations produces a number that moves wildly from quarter to quarter and tells the reader almost nothing useful.
Investment committees use the figure to set boundaries in a manager's mandate. Instructing a manager to keep tracking error between 3% and 6% grants freedom to be different while ruling out both closet indexing and unauthorised risk taking.
In practice
Real-world examples.
Example
A pension trustee compares two index funds tracking the same global equity index. One reports a tracking error of 0.08% and the other 0.62%, and the trustees choose the first because tighter tracking is the whole purpose of the allocation.
Example
An investment consultant reviews an active manager charging 0.75% a year with a tracking error of 0.9%. The consultant recommends termination on the grounds that so little difference from the index cannot justify the fee.
Example
A charity's mandate caps tracking error at 4% against a bond benchmark. When the manager's positioning pushes the measured figure to 5.3%, the compliance team requires the portfolio to be brought back within the limit within a quarter, and the manager reduces an oversized position in long dated bonds to comply.
Think of it
“Tracking error is how much you deviate from benchmark-difference in returns.
Formula
Calculation
Tracking error = the standard deviation of the differences between portfolio returns and benchmark returns over a series of periods.
A fund's annual returns for five years differ from its benchmark by +1.4%, -1.0%, +0.6%, -1.2% and +0.2%. These differences sum to 0.0%, so the average difference is 0.0% and the fund has matched the index over the period.
Squaring each difference gives 1.96, 1.00, 0.36, 1.44 and 0.04, which total 4.80. Dividing by four, one fewer than the number of observations, gives 1.20, and the square root of 1.20 is approximately 1.10.
The tracking error is therefore about 1.10% a year, meaning that in a typical year this fund lands within roughly 1.1 percentage points of its benchmark in either direction.Case study
Seen in the real world.
The following is an illustrative and fictional case. Ashcombe Pension Trust, an invented occupational scheme, held $400,000,000 with an active equity manager that had beaten its benchmark in seven of ten years. The trustees were content until a consultant analysed the pattern of those wins.
The fictional analysis showed a tracking error of only 0.7%, meaning the manager's portfolio was nearly identical to the index. Of the 0.4% average annual outperformance measured before fees, the 0.65% charge meant investors were behind after costs despite the run of positive years.
Ashcombe moved 80% of the mandate to an index fund with a tracking error of 0.06% and gave the remaining 20% to a genuinely concentrated manager with a tracking error above 6%. The illustrative outcome was the same overall risk profile at roughly a third of the fee.
Watch out
Common mistakes.
- Reading a low tracking error as good and a high one as bad, when the right level depends entirely on what the fund was hired to do.
- Confusing tracking error with the average difference in returns, when it measures the variability of that difference rather than its size.
- Judging tracking error over a single year, when the calculation needs several periods before it means anything.
Questions
People also ask.
What causes tracking error in an index fund?
Fees, trading costs, cash held for redemptions, sampling instead of full replication and delays in reflecting index changes.
Is tracking error the same as active risk?
Yes, the two terms are used interchangeably in most investment reporting.
How does tracking error relate to the information ratio?
The information ratio divides average outperformance by tracking error, showing how much excess return a manager delivers per unit of the risk taken.
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