What is tracking error

Managed portfolios behave slightly differently from their benchmark indexes on a day-to-day, month-to-month, and year-to-year basis—even portfolios designed to perfectly track their benchmark. Tracking error measures the degree of this wobble. How do you calculate tracking error? Tracking error is formally defined as the standard deviation of the difference between the returns of the portfolio and the returns of the benchmark—or the dispersion of the excess portfolio returns compared with its benchmark.

Why is tracking error important? Tracking error distills all the differences between a portfolio and its benchmark into a single number. It indicates to portfolio managers how close they are to the benchmark, which is important to know since the benchmark value contains the consensus view of a large number of intelligent market participants.

It also plays an important client communication role in that it sets appropriate expectations for how large the difference between the benchmark and the portfolio return will likely be. What is a good tracking error? Active portfolio managers typically show a large tracking error because they seek excess return alpha through their active positioning versus the benchmark. Passive managers, on the other hand, usually seek to demonstrate low tracking error—like the 0.

Theoretically an index fund should have a tracking error of zero relative to its benchmark. Absolute return, benchmark-agnostic strategies could have even higher tracking errors. Calculating tracking error is a three-step process. First, an excess return series is created by calculating the periodic differences between the manager and the benchmark.

Next, the mean of that excess return series is calculated. Finally, the dispersion of individual observations from the mean excess return is calculated.

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Number The asset class median is ARKK is an actively managed fund. According to its prospectus, ARKK seeks to invest in companies that it determines are engaged in disruptive innovation. It stands to reason that these types of companies would not have the same returns trends as an index made up of more stable stock.

Again, this makes sense. Tracking error and tracking difference can both be used to analyze funds. While tracking error shows how often and how much the portfolio varies from the index, tracking difference is just the difference in return over a certain time period.

It is possible for a fund to have a high tracking error but low tracking difference if its returns are often different from the index but end up around the same at the end of the period. When analyzing a fund, you can use tracking error to find how consistently the fund tracks the index and tracking difference to find how close the performance is. You can use tracking error to analyze a new fund or to ensure an existing investment is doing what it should be.

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Develop and improve products. List of Partners vendors. Your Money. Personal Finance. Your Practice. Popular Courses. What Is a Tracking Error? Key Takeaways Tracking error is the difference in actual performance between a position usually an entire portfolio and its corresponding benchmark.

The tracking error can be viewed as an indicator of how actively a fund is managed and its corresponding risk level. Evaluating a past tracking error of a portfolio manager may provide insight into the level of benchmark risk control the manager may demonstrate in the future. Article Sources.