Tracking error
InvestingDefinition
The standard deviation of an active fund's returns minus its benchmark's returns. Measures how closely (or loosely) a fund hugs its index.
Index funds have tracking error of 0.05-0.30%. Heavily active funds can have 5-15%. High tracking error isn't bad — it's the signature of a manager taking real bets — but it should be paired with positive alpha to be worth the fees.
Index funds have tracking error of 0.05-0.30%. Heavily active funds can have 5-15%. High tracking error isn't bad — it's the signature of a manager taking real bets — but it should be paired with positive alpha to be worth the fees.
Formula
TE = StdDev(Active return − Benchmark return)
Example
A US large-cap fund returns 8% in a year when the S&P 500 returns 10%. Difference = -2%. Compute the standard deviation of monthly differences over time → tracking error of, say, 4%. The fund deviates ~4% per year on average from the index.