A measure of the difference between the return fluctuations of an investment portfolio and the return fluctuations of a chosen benchmark
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What is Tracking Error?
Tracking error is a measure of financial performance that determines the difference between the return fluctuations of an investment portfolio and the return fluctuations of a chosen benchmark. The return fluctuations are primarily measured by standard deviations.
Generally, a benchmark is a diversified market index that represents part of the total market. The most common benchmarks for equity portfolios are the S&P 500 and the Dow Jones Industrial Average (DJIA) for portfolios with large-cap stocks, and the Russell 2000 for small-cap portfolios.
Importance of Tracking Error
Tracking error is one of the most important measures used to assess the performance of a portfolio, as well as the ability of a portfolio manager to generate excessive returns and beat the market or the benchmark. Due to the abovementioned reasons, it is used as an input to calculate the information ratio.
Tracking error is frequently categorized by the way it is calculated. A realized (also known as “ex post”) tracking error is calculated using historical returns. A tracking error whose calculations are based on some forecasting model is called an “ex ante” tracking error.
Low errors indicate that the performance of the portfolio is close to the performance of the benchmark. Low errors are common with index funds and ETFs that replicate the composition of major stock market indices.
High errors reveal that the portfolio’s performance is significantly different from the performance of the benchmark. The high errors can indicate that the portfolio substantially beat the benchmark, or signal that the portfolio significantly underperforms the benchmark.
Formula for Tracking
Tracking efficiency is calculated using the following formula:
Where:
- Var – the variance
- rp– the return of a portfolio
- rb– the return of a benchmark
Example of Tracking Error
Five years ago, Sam invested $100,000 in Fund A. The fund primarily invests in large-cap US equities. During the five-year period, the fund showed positive returns. Also, the economy also grew during the period and equity markets rose.
In order to assess how successful his investment was, Sam decides to compare the returns of Fund A against the returns of a benchmark. In such a case, the most appropriate benchmark is the S&P 500 because it tracks the performance of the biggest large-cap companies.
The comparison of the fund against the benchmark can be measured using the tracking error.
The following data is available for the yearly returns for both Fund A and the S&P 500:
We can plug this data into the formula to calculate the tracking error:
In the scenario above, the small tracking error indicates that Fund A does not significantly outperform the benchmark. Therefore, Sam may consider withdrawing his money from the fund and putting it into other, more promising investment opportunities. Alternatively, he may be satisfied with the fact that his portfolio is keeping pace with the gains of the overall market.
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FAQs
In an ideal case scenario, an index fund must have a tracking error of zero when comparing performance to its benchmark. But in reality, index funds lean towards the 1%, -2% range.
What is a good level of tracking error? ›
The acceptable level of tracking error is determined by each investor. Tracking error is neither good, nor bad. The performance of a portfolio with a 1.0 tracking error to its benchmark can be either higher or lower than the performance of the benchmark.
Is tracking error always positive? ›
It is important to note that tracking error is directionally agnostic, in that it measures only the volatility of excess returns, and says nothing about the direction – positive or negative - of the return differential.
What is a good ETF tracking error? ›
Most of the time, the tracking error of an index fund is small, perhaps only a few tenths of one percent. However, a variety of factors can sometimes conspire to open a gap of several percentage points between the index fund and its target index.
What is an acceptable amount of error? ›
The acceptable margin of error usually falls between 4% and 8% at the 95% confidence level.
What is considered a small tracking error? ›
Tracking Error is a measure of how well the fund tracks the benchmark during the investment period. It is a measure of volatility. A small tracking error indicates that the passive fund will tend to follow its benchmark very closely throughout, whereas a large tracking error indicates the opposite.
What is a high tracking error example? ›
Tracking error measures how well an investment portfolio follows its benchmark index. To calculate it, subtract the benchmark's return from the portfolio's. For example, if the portfolio earns 8% and the benchmark earns 7%, the tracking error is 1%. It indicates how much the portfolio deviates from the benchmark.
What is the tracking error standard? ›
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)
Is tracking error a measure of risk? ›
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 do you explain tracking error? ›
Tracking error is measured as the standard deviation of excess returns over time. It's an indicator of how consistently close or wide an index ETF's performance is relative to its benchmark. For investors using indexed products, any uncertainty around performance adds uncertainty costs.
A low tracking error means the portfolio is beating the index consistently over time. A high tracking error means that the portfolio returns are more volatile over time and not as consistent in exceeding the benchmark.
Is a high tracking error good for index funds? ›
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.
Do you want a high or low tracking error? ›
Passive fund managers aim for a low Tracking Error. Lower Tracking Error means that the fund tends to hew pretty close to the index in terms of its performance. A higher one means that the fund is all over the place and probably doing something that's quite different from the index.”
Is tracking error the same as volatility? ›
In laymen's terms, tracking error basically looks at the volatility in the difference of performance between the fund and its index. So, what factors affect how well a fund tracks its index? An ETF's total expense ratio (TER) is the single best indicator of future tracking difference.
What is the maximum tracking error? ›
The tracking error is the annualized standard deviation of the difference in daily returns between the underlying equity index and the NAV of the ETF/ Index Fund based on past one-year rolling data and must be within 2% levels.
What is the standard error of tracking error? ›
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 a large tracking error? ›
In the short term, a high tracking error means higher uncertainty in performance, thus eroding the value of a tactical trade. In the long term, tracking error can be used to evaluate how consistently an index fund manager is meeting benchmark returns over time.
What is the average tracking error for active funds? ›
Alford et al (2003) suggest that a “passive” fund is one with an annualised tracking error of less than 1.0%, while a “structured” fund should display an annualised tracking error between 1% and 5% and an “active” fund should show an annualised tracking error above 5%.
Do you want a higher or lower tracking error? ›
Passive fund managers aim for a low Tracking Error. Lower Tracking Error means that the fund tends to hew pretty close to the index in terms of its performance. A higher one means that the fund is all over the place and probably doing something that's quite different from the index.”
