Tracking Error | Meaning, Causes, Formula, Example, Importance & Limitations

If you’ve ever dipped your toes into the world of investing, you’ve probably come across the term tracking error. It might sound technical, but understanding it is easier than you think. In fact, it can help you feel more in control of your investments, whether you’re just starting out or are more experienced. Let’s break it down in a way that makes sense without all the jargon.

What is Tracking Error?

Tracking error measures the difference between the returns of an investment portfolio and its benchmark index. Essentially, it shows how well a portfolio tracks (or mimics) the performance of a specific index.

• High tracking error means the portfolio’s returns are quite different from the index.
• Low tracking error means the portfolio’s returns are closely aligned with the index.

For example, if you’re investing in an S&P 500 index fund, you’d expect the fund to closely match the performance of the S&P 500. If there’s a significant gap, that’s where tracking error comes in.

What Causes Tracking Error?

Tracking error can occur due to several factors. Some common reasons include:

• Management Style: Some funds are managed by people trying to beat the market rather than just follow it. Naturally, this will cause some differences.
• Fees and Costs: Management fees or transaction costs can eat into your returns, causing the fund to perform a bit differently than the index.
• Dividends and Income: Sometimes, the timing of when a fund receives and reinvests dividends doesn’t perfectly align with the index.
• Cash Holdings: If the fund holds cash, it might not generate the same returns as the index, which is typically fully invested in stocks.
• Market Timing: Some managers might try to shift the portfolio around to catch opportunities, which can create a bigger gap between the fund’s performance and the index.

How is Tracking Error Calculated?

Tracking error is typically expressed as the standard deviation of the difference between the portfolio’s returns and the benchmark’s returns over a period of time.

The formula looks like this:

Where:

• $R_p$ is the portfolio return.
• $R_b$ is the benchmark return.
• $n$ is the number of observations.

In simple terms, it’s a way to measure how consistently a portfolio’s returns differ from its benchmark.

Why Does Tracking Error Matter?

Now, you might be wondering, why should I even care about tracking error? Well, it can tell you a lot about whether the fund is doing what you expect it to do. Here’s why it matters:

• Risk Assessment: If you’re investing in an index fund (like one that tracks the S&P 500), you want a low tracking error. A low number means it’s sticking closely to the index, as it should.
• Understanding Manager Performance: A high tracking error might be expected if you’re investing in a fund where the manager is trying to beat the market. But keep in mind that a higher tracking error also means more risk.
• Cost Implications: Funds with high tracking errors often have higher fees. It’s important to assess whether the extra costs are justified by any outperformance the fund might deliver.

Example of Tracking Error

Let’s say you’ve invested in two different funds:

• Fund A: Its tracking error is 0.2%, meaning it’s almost perfectly aligned with the index. This would be great for someone who wants a predictable, low-cost fund that mirrors the market.
• Fund B: Its tracking error is 3%. This fund is taking more risks and might outperform the index at times, but it’s also straying further from the benchmark. This could be attractive if you’re looking for higher returns, but you should be comfortable with the extra risk.

What is a "Good" Tracking Error?

This depends on what kind of investor you are. For passive funds that are designed to follow an index, you want the tracking error to be as low as possible, maybe under 0.5%. For active funds, a tracking error of 3% or more might be normal, but anything much higher could indicate the fund is taking significant risks.

Does Tracking Error Tell You Everything?

Not quite. A low tracking error isn’t always a guarantee of success, and a high tracking error doesn’t always mean failure. It’s simply a measure of how closely a fund is sticking to its benchmark. Depending on your investment goals, both high and low tracking errors can be okay—as long as you understand what you’re getting into.

Importance of Tracking Error

1. Helps You See How Well a Fund is Doing: Tracking error gives you a simple way to check if a fund is staying on track with its goal of following a benchmark.
2. Shows How Risky a Fund Might Be: If a fund has a high tracking error, it’s like a heads-up that it might be taking bigger risks and drifting away from its target.
3. Guides Your Investment Choices: Knowing a fund’s tracking error helps you decide if it’s the right fit—especially if you’re expecting it to behave a certain way, like matching an index.
4. Tells You How Active Management is Working: For funds where managers try to outperform the market, tracking error shows just how different their approach is from the benchmark.
5. Helps You Know if Fees Are Worth It: Tracking error helps you see if the extra fees you're paying make sense for the fund’s performance. You don’t want to pay more for a fund that’s straying too far from its goal.

Limitations of Tracking Error

1. Doesn’t Indicate Direction: It shows how much a fund deviates from the benchmark but not whether the deviation is positive or negative.
2. Not a Measure of Absolute Performance: It only shows the variance from the benchmark, not whether the fund is making money or losing money.
3. Limited to Relative Performance: Tracking error focuses on how a fund compares to an index but doesn’t consider broader market conditions or other benchmarks.
4. Overemphasis on Consistency: A low tracking error can mean a fund is stable, but it could also mean it’s playing it too safe and missing chances to do better than the index.
5. Doesn’t Align With Personal Goals: Not everyone wants a fund that sticks close to the benchmark. If you’re after bigger returns, a low tracking error might not be what you’re looking for.

Final Thoughts: How Tracking Error Can Help You Invest Smarter?

Tracking error is like a signal that lets you know how well a fund is doing compared to its benchmark. Whether you want a fund that mirrors the market or one that takes some risks for potentially higher returns, tracking error is a useful tool in your investment toolbox. By understanding tracking error, you can better evaluate your investments, manage your expectations, and, ultimately, make more informed decisions that align with your financial goals.