Tracking Error

Tracking error measures the consistency of a portfolio's deviation from its benchmark. It's the standard deviation of the active return (portfolio return minus benchmark return).

Formula: Tracking Error = σ(Rp - Rb)

Interpreting Tracking Error:

Tracking Error	Type of Fund	Meaning
0.0 - 0.2%	Passive index fund	Nearly perfect tracking
0.2 - 1.0%	Enhanced index	Slight deviations from index
1.0 - 5.0%	Active fund (low)	Modest active bets
5.0 - 15.0%	Active fund (high)	Significant active management
> 15.0%	Highly active/hedge fund	Very different from benchmark

Sources of Tracking Error:

• Fees and expenses (guaranteed drag for index funds)
• Cash drag (holding cash instead of being fully invested)
• Sampling (not holding every security in the index)
• Rebalancing timing (index changes vs. fund rebalancing)
• Active decisions (deliberate over/underweights for active funds)

For Index Fund Investors:

• Look for tracking error below 0.2% for broad market ETFs
• Higher tracking error in index funds = higher costs or poor management
• Compare tracking error across similar index funds when choosing

For Active Fund Evaluation:

• High tracking error + high alpha = skilled active manager
• High tracking error + low alpha = taking risks without reward
• Low tracking error + any alpha = closet indexer (not worth active fees)