Tracking error measures how much a portfolio’s returns deviate from its benchmark. It quantifies the “active risk” taken by deviating from the index.
Beginner
What It Means
Tracking error tells you how differently your portfolio behaves compared to its benchmark. Low tracking error means your portfolio closely mirrors the benchmark. High tracking error means you’re making big bets away from the index.
Portfolio Example
| Portfolio | Tracking Error | Interpretation |
|---|
| Index Fund | 0.1% | Almost identical to benchmark |
| Enhanced Index | 1-2% | Small active bets |
| Active Fund | 4-6% | Significant active management |
| Concentrated | 8%+ | Very different from benchmark |
Why It Matters
Tracking error helps you understand:
- How “active” your manager really is
- Whether you’re paying active fees for passive-like returns
- The range of likely performance vs. benchmark
Advanced
Mathematical Definition
Tracking Error = Standard Deviation of (Portfolio Return - Benchmark Return)
TE = σ(Rp - Rb)
Where:
- Rp = Portfolio return
- Rb = Benchmark return
Interpreting Tracking Error
With 4% tracking error, about 68% of the time your portfolio will perform within plus or minus 4% of the benchmark annually.
| Tracking Error | Active Risk Level |
|---|
| 0-1% | Passive/Index |
| 1-3% | Enhanced index |
| 3-6% | Moderate active |
| 6-10% | High active |
| 10%+ | Very concentrated |
Ex-Ante vs. Ex-Post
| Type | Definition | Use |
|---|
| Ex-Ante | Predicted future tracking error | Risk budgeting, portfolio construction |
| Ex-Post | Historical realized tracking error | Performance evaluation |
Ex-ante tracking error is estimated from holdings and factor exposures. Ex-post is calculated from actual return differences. They often differ significantly.
Sources of Tracking Error
| Source | Description |
|---|
| Stock Selection | Different weights vs. benchmark |
| Sector Bets | Over/underweight sectors |
| Factor Tilts | Value, momentum, size exposures |
| Cash Drag | Holding cash when benchmark is fully invested |
| Timing | Different rebalancing timing |
Information Ratio = Alpha / Tracking Error
High IR = Efficient use of active risk
Low IR = Taking risk without commensurate return
| IR | Interpretation |
|---|
| Below 0.3 | Weak active management |
| 0.3 - 0.5 | Median manager |
| 0.5 - 0.75 | Top quartile |
| Above 0.75 | Top decile |
Tracking Error Budgeting
Institutional investors often set tracking error budgets:
Example:
- Total TE budget: 4%
- Stock selection: 3%
- Sector bets: 2%
- Factor tilts: 1%
Note: These don't add linearly due to correlations
Closet Indexing
Closet Indexing: Funds with low tracking error (under 2%) but charging active management fees. You’re paying for active management but getting near-index returns.
- Tracking error under 2%
- R-squared above 0.95
- High benchmark correlation
- Many holdings similar to index
Tracking Error vs. Total Risk
| Metric | Measures | Reference Point |
|---|
| Standard Deviation | Total volatility | None (absolute) |
| Tracking Error | Active volatility | Benchmark (relative) |
Data Requirements
| Requirement | Details |
|---|
| Minimum | 24 months for basic estimate |
| Preferred | 36-60 months for stable measurement |
| Frequency | Monthly returns typical |
