A passive fund or an exchange traded fund (ETF) attempts to perfectly mimic an index. However, their returns don’t perfectly trail the respective index.
Tracking Error measures this variability. It is the annualized standard deviation of daily return differences between the total return performance of the fund and the total return performance of its underlying index.
Tracking Error is the variation between the performance of a portfolio and the performance of the portfolio’s benchmark over time. Why would there be a difference? Because of the expense ratio, and transaction and rebalancing costs.
Russ Kinnel, director of manager research, Morningstar, on why it is different for active and passive funds.
Tracking Error is very commonly used in the investment industry, and essentially, it's telling you about volatility in a fund that's not explained by its index's movement.
Standard Deviation tells you the absolute amount up and down, whereas Tracking Error tells you how different the fund is from the index. If the index is up 20% and a fund is up 30%, that's pretty different, as opposed to another fund maybe that's up 21% that would have a lower Tracking Error.
Active fund managers show a large Tracking Error because they seek excess return (alpha) through active positioning versus the benchmark. Passive fund managers aim for a low Tracking Error. Lower Tracking Error means that the fund tends to hew pretty close to the index in terms of its performance. A higher one means that the fund is all over the place and probably doing something that's quite different from the index.
Jose Garcia Zarate, associate director of passive strategies, Morningstar, on Tracking Difference and Tracking Error.
Tracking Difference is the absolute difference between the returns of the fund and those of the benchmark at the end of the chosen investing period. For example, if you hold a passive fund for three years, the tracking difference is a single measure calculated right at the end of the 3-year investment period and tells you what you get relative to the benchmark once you exclude the fund’s charges over the period.
Tracking Error is a measure of how well the fund tracks the benchmark during the investment period. It is a measure of volatility. A small tracking error indicates that the passive fund will tend to follow its benchmark very closely throughout, whereas a large tracking error indicates the opposite.
A useful analogy to understand these concepts is that of race between two cars, where one car is the index and the other is the fund. Tracking Difference would be the time difference between the two cars at the finish line. Tracking Error tells you how close the two cars were to each other during the race.
How it is worked out, as explained in Morningstar Direct.
Tracking Error is a measure of the volatility of excess returns relative to a benchmark.
Given a sequence of returns for an investment or portfolio and its benchmark, Tracking Error is calculated as follows:
- Tracking Error = Standard Deviation of (P–B)
- P = the return of the investment
- B = the return of the benchmark
Assume that there is a large-cap fund that is benchmarked to the S&P 500 index. Next, assume that the mutual fund and the index realized the follow returns over a given 5-year period:
The standard deviation of this series of differences, the Tracking Error, is 2.79%.
If you make the assumption that the sequence of return differences is normally distributed, you can interpret Tracking Error in a very meaningful way. In the above example, it can be expected that the mutual fund will return within 2.79%, plus or minus, of its benchmark approximately every two years out of three.
From an investor point of view, Tracking Error can be used to evaluate portfolio managers. If a manager is realizing low average returns and has a large Tracking Error, it is a sign that there is something significantly wrong with that investment and that the investor should most likely find a replacement.