Tracking Error

This statistic measures the standard deviation of a fund’s excess returns over the returns of an index or benchmark portfolio. As such, it can be an indication of “riskiness” in the manager’s investment style. A tracking error below 2 suggests a passive approach, with a close fit between the fund and its benchmark. At 3 and above, the correlation is progressively looser and indicates that the manager will be deploying a more active investment style and taking bigger positions away from the composition of the benchmark.

While zero tracking error would indicate a fund that was a perfect replication of its benchmark portfolio, this is hardly likely to be encountered in reality. The fund will not be fully invested at all times in its benchmark components, since an element of liquidity will need to be retained for redemptions, and the assumed reinvestment of dividends will not always be possible. Transaction costs dilute returns — and proportionately more so in smaller funds. Issues of timing and availability mean that changes in the benchmark’s constituents cannot be instantaneously mirrored in the fund’s portfolio. These factors will all produce greater tracking error — and be reflected in the beta and r-squared ratios. Ultimately, this is actually only an “error” if the investment strategy goes unrewarded by outperformance of the benchmark.

Both tracking error and annualized tracking error are available.