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Tracking Error

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Tracking Error is performance measurement term which quantifies the extent to which mutual fund portfolio's return is at variance with the underlying benchmark. In the case of Index Funds, this number is very important. An index fund is expected to replicate the index and therefore have a minimal tracking error. Index funds are compared and ranked on the basis of their tracking errors.

If tracking error is measured historically, it is called 'realised' or 'ex post' tracking error. If a model is used to predict tracking error, it is called 'ex ante' tracking error. The former is more useful for reporting or analysis purposes, whereas exact is generally used by portfolio managers to control risk to satisfy client guidelines.

Tracking error is mathematically the same as Active Risk, and has historically been used in the context of index portfolio or fund management, but, especially in Europe, is now typically used to describe the standard deviation of returns, either active or passive. The active return is the difference in the return of a portfolio and its benchmark. An index manager aiming to match the return of a benchmark index seeks to minimize realised tracking error, i.e., the standard deviation of returns about the benchmark. An active portfolio manager, on the other hand, aims to achieve a positive active return with a low active risk.

Tracking Error = stdev(RETURN(portfolio) - beta * RETURN(index))

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