Tracking Error

Key Highlights

• Tracking error indicates how much an investment portfolio’s returns differ from its benchmark index, such as the S&P 500.

• It captures the ups and downs of the difference between the portfolio’s returns and the benchmark’s returns.

What Is Tracking Error?

Tracking error indicates how much an investment portfolio’s returns differ from its benchmark index, such as the S&P 500. It captures the ups and downs of the difference between the portfolio’s returns and the benchmark’s returns.

Why Does Tracking Error Matter?

A low tracking error means your portfolio sticks closely to the benchmark, which is great for funds designed to mirror an index. A higher tracking error signals bigger differences, which might mean more risk or an intentional strategy to beat the benchmark. Investors and fund managers use tracking error to understand how much a portfolio’s performance might stray from its goal.

Factors Affecting Tracking Error

Several things can cause tracking error to go up or down:

• Portfolio Differences: If the portfolio holds different stocks or assets than the benchmark, returns may vary.

• Costs and Fees: Trading fees or management costs can create gaps between the portfolio and benchmark.

• Manager Choices: Active managers who pick stocks to outperform the benchmark often increase tracking error.

• Index Changes: When a benchmark updates its holdings, delays or differences in adjusting the portfolio can lead to deviations.

How Is Tracking Error Used?

Tracking error is a key tool for investors:

• Passive Investing: The objective is to minimize tracking error to ensure the portfolio mirrors the benchmark's performance as accurately as possible.

• Active Investing: Some tracking error is expected as managers take risks to try and beat the benchmark.