The term tracking error refers to a measure that allows an investor to understand how close a fund follows its benchmark index. Tracking error is the standard deviation of the difference between the return of a mutual fund, or exchange traded fund, and its benchmark index.
One of the ways to measure the effectiveness of an investment portfolio is by calculating its tracking error. Also known as active risk, tracking error is calculated by taking the standard deviation of the difference between a fund's return and a benchmark index, which is typically used to measure the performance of a mutual fund or exchange traded fund (ETF). For example, a mutual fund might attempt to replicate, or beat, the S&P 500 Index.
The objective of an actively managed fund is to outperform an index, while a passively managed fund attempts to provide the same returns as an index. A fund's active return measures the difference between a fund's annual return and its benchmark index. If an actively managed fund provided investors with a return of 12.3%, and its benchmark's return was 15.6%, then the fund's active return would be -3.3%.
The fund's tracking error allows the investor to understand how much these active returns deviate from the benchmark over time. It tells the investor something about the variability of the fund's returns relative to its index. For this reason, tracking error is typically evaluated alongside the fund's active return.