Tracking error is the variation between the performance of a portfolio and the performance of the portfolio’s benchmark over time. It’s calculated as the standard deviation of the difference of a sequence of portfolio returns and index returns.
Investors can use tracking error can to gauge how well an index fund is managed and to find out how actively a fund is managed. Let’s go over how it is calculated and used and what it should mean to you as an individual investor.
Definition and Examples of Tracking Error
Tracking error is the standard deviation difference of a sequence of portfolio returns and the returns of the benchmark the portfolio is based on or related to. For index funds, tracking error can be due to trading costs or other friction. For active funds, you should expect tracking error—the manager’s goal is to depart from the index and reduce correlation.
For actively managed funds or portfolios, tracking error is also called “active manager risk.” Risk and error generally have negative connotations, but, in this context, they are not necessarily negative.
If you’re looking for an investment that will reduce correlation to a benchmark index, tracking error from that index is the goal. And for active managers to outperform the index, they necessarily must increase “risk.”
How Tracking Error Works
Let’s use two ETFs to show how tracking error works. The index fund we’ll use is the SPDR S&P 500 ETF (SPY). The actively managed fund we’ll use is the ARK Innovation ETF (ARKK).
SPY is an S&P 500 index fund. It exists to mimic the S&P 500 and is a passively managed fund. Any tracking error it has is friction to your investments over time. In its prospectus, the fund manager notes that fees and expenses can create an imperfect correlation between how the fund performs and its benchmark.
According to Fidelity, SPY’s tracking error in August 2021 is just 0.03. The asset class median is 10.41, which means the standard deviation of the difference in SPY’s returns and the actual S&P 500’s is low compared to other ETFs with the same stocks.
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.
As such, ARKK’s tracking error was 34.71 in August 2021, more than three times the median number. Again, this makes sense. If you were paying up (and ARKK’s expense ratio of 0.75% is far more than SPY’s of 0.09%) for an actively managed fund, you don’t want to end up with the same tracking error as a passively managed fund like SPY.
Tracking Error vs. Tracking Difference
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.
What It Means for Individual Investors
You can use tracking error to analyze a new fund or to ensure an existing investment is doing what it should be. If you’re looking for an index fund to diversify your portfolio, make sure it has low tracking error so that your returns aren’t being eaten away by costs. If you pay more for an actively managed fund to try to beat the market, you don’t want low tracking error because you could just buy an index fund and get the same result, in theory.
- Tracking error is the variance between a portfolio’s returns and an index’s returns.
- Index funds have low tracking error and actively managed funds have high tracking error.
- Tracking difference is the return difference over a specific time period between a portfolio and index while tracking error shows how often the portfolio has different returns.