What Is Tracking Error?
Let me explain tracking error directly: it's the difference between how a portfolio or position performs compared to its benchmark. You see this often in hedge funds, mutual funds, or ETFs where the results don't match the intended benchmark, leading to unexpected gains or losses. We report it as a standard deviation percentage, showing how your returns differ from the benchmark you're trying to match.
Understanding Tracking Error
As an investor, you should know that tracking error measures consistency against a benchmark over time. Even perfectly indexed portfolios differ slightly from their benchmarks on a daily, quarterly, or yearly basis. This metric quantifies that difference. Calculate it as the standard deviation of (P - B), where P is your portfolio return and B is the benchmark return. If you're evaluating a manager, a high tracking error with low returns signals problems—consider replacing them. Quantitative managers use it to build portfolios that stick close to benchmarks by matching factors like style or market cap.
Factors That Affect Tracking Error
Several elements influence tracking error, and I'll outline them here. Fund fees naturally drag down NAV compared to fee-free indices, but skilled managers can offset this through rebalancing or securities lending. Your fund's holdings might not perfectly match the index due to sampling or weighting differences. Illiquid securities widen bid-ask spreads, increasing error, especially in volatile sectors. Premiums or discounts to NAV, optimization for thin stocks, diversification rules, cash drag from dividends, index changes, capital-gains distributions, securities lending, currency hedging, futures rolls, and maintaining leverage in leveraged ETFs all play roles. Sector or international ETFs often show higher errors than broad equity or bond ones.
Ex-Post vs. Ex-Ante Tracking Error
You need to distinguish between ex-post and ex-ante tracking errors. Ex-post looks back at actual past deviations, useful for evaluating performance. Ex-ante predicts future deviations using models and current data, aiding in risk management. Ex-post relies on historical returns, making it straightforward; ex-ante requires forecasting, which is more complex.
Tools to Monitor Tracking Errors
Depending on your needs, various tools help monitor tracking errors. For basic use, spreadsheets like Excel let you input returns and compute standard deviations manually. Advanced users turn to platforms like Morningstar Direct or Bloomberg Terminal for automated analytics. Institutional players use systems like BlackRock's Aladdin for real-time, integrated modeling.
Example of Tracking Error
Consider a large-cap mutual fund benchmarked to the S&P 500 with these five-year returns: fund at 11%, 3%, 12%, 14%, 8%; index at 12%, 5%, 13%, 9%, 7%. Differences are -1%, -2%, -1%, 5%, 1%. The standard deviation? 2.50%. That's your tracking error.
Frequently Asked Questions
- What is tracking error? It's the standard deviation of differences between portfolio and index returns, measuring replication closeness.
- How do you calculate it? Subtract benchmark returns from portfolio returns per period, then take the standard deviation of those differences.
- What causes tracking errors? Fees, cash drag, rebalancing timing, and composition differences all contribute.
- Why does it matter? Low tracking error means your fund effectively mimics the index, crucial for passive strategies.
The Bottom Line
In summary, tracking error tells you how well a portfolio tracks its benchmark through standard deviation of return differences. Aim for low errors in index funds and ETFs to ensure accurate replication.
Other articles for you
The Master of Public Administration (MPA) is a graduate degree that equips individuals for leadership and management positions in government, nonprofits, and related fields.
An optionable stock meets specific exchange criteria allowing its options to be listed and traded, enabling better risk management for investors.
Trade volume measures the total shares or contracts traded for a security in a given period, indicating market activity and liquidity.
Price leadership is when a dominant firm sets prices that others in the industry must follow to maintain market share.
An economic recovery is the phase after a recession where the economy rebounds with growing GDP, rising incomes, and falling unemployment.
Economic efficiency involves optimally allocating scarce resources to maximize welfare and minimize waste in production and consumption.
Real options give company managers flexible choices to adapt business projects involving tangible assets based on changing conditions.
A Bill of Materials (BOM) is a comprehensive list detailing the components, materials, and instructions needed to build, manufacture, or repair a product.
SEC Release IA-1092 is a 1987 memo clarifying how state and federal laws apply to investment advisers and financial planners, expanding on the 1940 Advisers Act.
Ex Works (EXW) is an international trade term where the seller makes goods available at a specified location, and the buyer handles all transport costs and risks.