Tracking Error Definition, Factors That Affect It, Example (2024)

What Is a Tracking Error?

Tracking error is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark. This is often in the context of ahedge fund,mutual fund,or exchange-traded fund(ETF) that did not work as effectively as intended, creating an unexpected profit or loss.

Tracking error is reported as a standard deviation percentage difference, which reports the difference between the return an investor receives and that of the benchmark they were attempting to imitate.

Key Takeaways

  • Tracking error is the difference in actual performance between a position (usually an entire portfolio) and its corresponding benchmark.
  • The tracking error can be viewed as an indicator of how actively a fund is managed and its corresponding risk level.
  • Evaluating a past tracking error of a portfolio manager may provide insight into the level of benchmark risk control the manager may demonstrate in the future.

Tracking Error

Understanding a Tracking Error

Since portfolio risk is often measured against a benchmark, tracking error is a commonly used metric to gauge how well an investment is performing. Tracking error shows an investment's consistency versus a benchmark over a given period of time. Even portfolios that are perfectly indexed against a benchmark behave differently than the benchmark, even though this difference on a day-to-day, quarter-to-quarter, or year-to-year basis may be ever so slight. The measure of tracking error is used to quantify this difference.

Tracking error is the standard deviation of the difference between the returns of an investment and its benchmark. Given a sequence of returns for an investment or portfolio and its benchmark, tracking error is calculated as follows:

Tracking Error = Standard Deviation of (P - B)
  • Where P is portfolio return and B is benchmark return.

From an investor's point of view, tracking error can be used to evaluate portfolio managers. If a manager is realizing low average returns and has a large tracking error, it is a sign that there is something significantly wrong with that investment and that the investor should most likely find a replacement.

It may also be used to forecast performance, particularly for quantitative portfolio managers who construct risk models that include the likely factors that influence price changes. The managers then construct a portfolio that uses the type of constituents of a benchmark (such as style, leverage, momentum, or market cap) to create a portfolio that will have a tracking error that closely adheres to the benchmark.

Special Considerations

Factors That Can Affecta Tracking Error

Thenet asset value(NAV)of an index fund is naturally inclined toward being lower than its benchmark because funds have fees, whereas an index does not. A highexpense ratiofor a fund can have a significantly negative impact on the fund's performance. However, it is possible for fund managers to overcome the negative impact of fund fees and outperform the underlying index by doing an above-average job of portfoliorebalancing, managing dividends or interest payments, or securities lending.

Beyond fund fees, a number of other factors can affect a fund's tracking error. One important factor is the extent to which a fund's holdings match the holdings of the underlying index or benchmark. Many funds are made up of just the fund manager's idea of a representative sample of the securities that make up the actual index. There are frequently alsodifferences in weighting between a fund's assets and the assets of the index.

Illiquidor thinly-traded securities can also increase the chance of a tracking error, since this often leads to pricesdiffering significantly from market price when the fund buys or sells such securities as a result of largerbid-ask spreads. Finally, the level of volatility for an index can also affect the tracking error.

Sector,international,anddividend ETFstend to have higher absolute tracking errors; broad-based equity andbond ETFstendto have lower ones.Management expense ratios(MER) are the most prominent cause of tracking error and there tends to be a direct correlation between the size of the MER and tracking error. But other factors can intercede and be more significant at times.

Premiums and Discounts to Net Asset Value

PremiumsordiscountstoNAV may occur when investors bid the market price of an ETF above or below the NAV of its basket ofsecurities. Such divergences are usually rare. In the case of a premium, the authorized participant typicallyarbitragesit away by purchasing securities in the ETF basket, exchanging them for ETF units, and selling the units on the stock market to earn a profit (until the premium is gone). Premiums and discounts as high as 5% have been known to occur, particularly for thinly traded ETFs.


When there are thinly traded stocks in the benchmark index, the ETF provider can't buy them without pushing their prices up substantially, so it uses a sample containing the more liquid stocks to proxy the index. This is called portfolio optimization.

Diversification Constraints

ETFs are registered with regulators asmutual fundsand need to abide by the applicable regulations. Of note are two diversification requirements: 75% of its assets must be invested in cash, government securities, and securities of other investment companies, and no more than 5% of the total assets can be invested in any one security. This can create problems for ETFs tracking the performance of a sector where there are a lot of dominant companies.

Cash Drag

Indexes don't have cash holdings, but ETFs do. Cash can accumulate at intervals due todividendpayments, overnight balances, and trading activity. The lag between receiving and reinvesting the cash can lead to adecline in performance known as drag. Dividend funds with high payoutyieldsare most susceptible.

Index Changes

ETFs track indexes and when the indexes are updated, the ETFs have to follow suit. Updating the ETFportfolioincurs transaction costs. And it may not always be possible to do it the same way as the index. For example, a stock added to the ETF may be at a different price than what the index maker selected.

Capital-Gains Distributions

ETFs are more tax-efficient than mutual funds but have nevertheless been known to distributecapital gainsthat are taxable in the hands of unitholders. Although it may not be immediately apparent, these distributions create a different performance than the index on an after-tax basis. Indexes with a high level of turnover in companies (e.g.,mergers,acquisitions,andspin-offs) are one source of capital-gains distributions. The higher the turnover rate, the higher the likelihood the ETF will be compelled to sell securities at a profit.

Securities Lending

Some ETF companies may offset tracking errors throughsecurity lending, which is the practice of lending out holdings in the ETF portfolio tohedge fundsforshort selling. The lending fees collected from this practice can be used to lower tracking error if so desired.

Currency Hedging

International ETFs with currency hedging may not follow a benchmark index due to the costs of currency hedging, which are not always embodied in the MER. Factors affecting hedging costs include market volatility and interest-rate differentials, which impact the pricing and performance of forward contracts.

Futures Roll

Commodity ETFs,in many cases, track the price of acommoditythrough thefutures markets, buying the contract closest to expiry. As the weeks pass and the contract nears expiration, the ETF provider will sell it (to avoid taking delivery) and buy the next month's contract. This operation, known as the "roll," is repeated every month. If contracts further from expiration have higher prices (contango), the roll into the next month will be at a higher price, which incurs a loss. Thus, even if the spot price of the commodity stays the same or rises slightly, the ETF could still show a decline. Vice versa, if futures further away from expiration have lower prices (backwardation), the ETF will have an upward bias.

Maintaining Constant Leverage

Leveraged and inverse ETFs useswaps, forwards, and futures to replicate on a daily basis two or three times the direct or inverse return of a benchmark index. This requires rebalancing the basket of derivatives daily to ensure they deliver the specified multiple of the index's change each day.

Example of a Tracking Error

For example, assume that there is a large-cap mutual fund benchmarked to the S&P 500 index. Next, assume that the mutual fund and the index realized the following returns over a given five-year period:

  • Mutual Fund: 11%, 3%, 12%, 14% and 8%.
  • S&P 500 index: 12%, 5%, 13%, 9% and 7%.

Given this data, the series of differences is then (11% - 12%), (3% - 5%), (12% - 13%), (14% - 9%) and (8% - 7%). These differences equal -1%, -2%, -1%, 5%, and 1%. The standard deviation of this series of differences, the tracking error, is 2.50%.

Tracking Error Definition, Factors That Affect It, Example (2024)


What is tracking error with example? ›

Tracking error is the standard deviation of the difference between the returns of an investment and its benchmark. Given a sequence of returns for an investment or portfolio and its benchmark, tracking error is calculated as follows: Tracking Error = Standard Deviation of (P - B)

What is an example of tracking error calculation? ›

The calculation for the simple tracking error for each period, which is the return for the ABC Market Fund less the Total Market Index return.
  • Year 1: 9.7% - 10% = -0.3%
  • Year 2: 4.6% - 5% = -0.4%
  • Year 3: 7.2% - 7% = 0.2%
  • Year 4: 2.2% - 2% = 0.2%
  • Year 5: 7.8% - 8% = -0.2%
  • Year 6: -1.8% - (-2%) = 0.2%
Dec 15, 2022

What affects tracking error? ›

The 3 key reasons why tracking errors occur in Index Funds are – Mutual Fund expenses, cash balance of Index Funds, and problems in buying/selling underlying index stocks. Let's look at each of these reasons in detail: Mutual Fund Expenses.

What is considered a good tracking error? ›

Theoretically, an index fund should have a tracking error of zero relative to its benchmark. Enhanced index funds typically have tracking errors in the 1%-2% range. Most traditional active managers have tracking errors around 4%-7%.

What is meant by tracking error? ›

In finance, tracking error or active risk is a measure of the risk in an investment portfolio that is due to active management decisions made by the portfolio manager; it indicates how closely a portfolio follows the index to which it is benchmarked.

How is tracking error used? ›

Tracking error serves as a neutral point and allows portfolio managers to make an informed decision. It helps investors to ascertain the significance of differences between the returns of benchmark and portfolio. Further helps to determine how active and proficient a portfolio manager's investment strategy is.

What are examples of error rate? ›

For example, if you send 100 requests per minute and 50 of them fail, that's a 50% error rate.

What is an example of amount of error? ›

For example, let's say you guessed that there were 230 gumballs in the image, but there were actually 311 gumballs. The difference between your guess (230) and the actual number (311) in comparison to the actual number (311) expressed as a percent is the percentage error.

Why is tracking error important? ›

Importance of tracking error

Helps understand the consistency of higher returns. Portfolio managers can use tracking error for ascertaining how close a portfolio is to its benchmark. Using a tracking error, investors can determine how proficient a portfolio manager's investment strategy is.

What is daily tracking error? ›

It is the annualized standard deviation of daily return differences between the total return performance of the fund and the total return performance of its underlying index. Tracking Error is the variation between the performance of a portfolio and the performance of the portfolio's benchmark over time.

What is tracking error and difference? ›

To sum it up, tracking error measures the variability rather than performance, while tracking difference measures the difference between an index fund's returns and the benchmark index.

Can tracking error be zero? ›

A portfolio created to match the benchmark index (i.e., an index fund) that regularly has zero active returns (i.e., always matches its benchmark's actual return) would have a tracking error of zero.

Can tracking error be negative? ›

Tracking difference is rarely nil: The ETF usually trails its index. That's because a number of factors prevent the ETF from perfectly mimicking its index. ETF returns don't always trail their index though; tracking difference can be small or large, positive or negative.

Is lower tracking error always better? ›

Therefore, tracking error indicates how well the index fund tracks the benchmark index during the investment tenure. A low tracking error signifies that the portfolio closely follows its benchmark index. At the same time, a high tracking error signifies that the portfolio is not following the benchmark.

How do you calculate tracking difference? ›

Calculating tracking difference is rather simple: Subtract the index's total return from the ETF's total return. Tracking difference can be positive or negative and reveals the extent to which an ETF outperforms or underperforms its benchmark index.

What does a high tracking error mean? ›

It is often assumed that a high amount of tracking error means that the fund has performed poorly relative to its benchmark, but it is not necessarily the case," he says. "In fact, a high tracking error doesn't necessarily imply anything about the magnitude of tracking difference over a given time period.

What is the difference between tracking difference and tracking error? ›

To sum it up, tracking error measures the variability rather than performance, while tracking difference measures the difference between an index fund's returns and the benchmark index.

Is tracking error the same as active risk? ›

Active risk, also known traditionally as tracking error or tracking risk, is a risk that a portfolio manager creates in an attempt to outperform benchmark returns against which it is compared. In addition, active risk helps a portfolio manager achieve higher returns for investors.

What is the difference between tracking error and expense ratio? ›

The expense ratio is the total expenses charged by the scheme. It is a percentage. Tracking error tells you whether the scheme managed to replicate the benchmark index. A lower tracking error is better.


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