# Understanding Tracking Error: Meaning, Influencing Factors, and Example

## What Is a Tracking Error?

Tracking error is the [divergence](https://www.investopedia.com/terms/d/divergence.asp) between the price behavior of a position or a portfolio and the price behavior of a benchmark. It is often used to gauge how well an index fund or exchange-traded fund (ETF) replicates the performance of its benchmark. It is also used to measure the performance of actively-managed funds.

Tracking error is reported as a standard deviation percentage difference, which reports the difference between the return an investor receives and that of the [benchmark](https://www.investopedia.com/terms/b/benchmark.asp) they were attempting to imitate.

### Key Takeaways

*   Tracking error quantifies the deviation between a portfolio's performance and its benchmark, often calculated as a standard deviation percentage.  
    
*   Several factors, including fund fees, portfolio composition, rebalancing strategies, and market volatility, can influence tracking error.  
    
*   Understanding both ex-post and ex-ante tracking error offers insights into historical performance and potential future deviations, respectively.  
    
*   Different types of ETFs, such as sector or international ETFs, often exhibit varying levels of tracking error based on their structure and market conditions.  
    
*   Tools ranging from basic spreadsheets to advanced software solutions like Bloomberg Terminal and MSCI Barra assist various investors in analyzing and managing tracking error effectively.in the future. 

![Tracking Error: The difference between the performance of an investment and its benchmark.](https://www.investopedia.com/thmb/62jIW4XvbbVLiCfchizlkOBTxVA=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/trackingerror.asp-final-9f4b41b5cf5a477ca6b0853a3af04ff8.png)

*— Investopedia / Julie Bang*

## How Tracking Error Affects Investment Performance

Since portfolio risk is often measured against a benchmark, tracking error is a commonly used metric to gauge how well an investment is performing. Tracking error shows an investment's consistency versus a benchmark over a given period of time. Portfolios indexed to a benchmark may still behave slightly differently from it over time. The measure of tracking error is used to quantify this difference.

Tracking error is the standard deviation of the difference between the returns of an investment and its benchmark. Tracking error is calculated by using the sequence of returns for a portfolio and its benchmark:

> Tracking Error = Standard Deviation of (P - B)

*   Where P is portfolio return and B is benchmark return.

Investors can use tracking error to evaluate [portfolio managers](https://www.investopedia.com/terms/p/portfoliomanager.asp). A large tracking error combined with low [average returns](https://www.investopedia.com/terms/a/averagereturn.asp) suggests issues with the investment, often prompting investors to seek alternatives.

It may also be used to forecast performance, particularly for quantitative portfolio managers who construct risk models that include the likely factors that influence price changes. The managers then construct a portfolio that uses the type of constituents of a benchmark (such as style, leverage, momentum, or market cap) to create a portfolio that will have a tracking error that closely adheres to the benchmark. 

## Key Influences on Tracking Error in Portfolios

 Index fund [net asset values](https://www.investopedia.com/terms/n/nav.asp#axzz1lc9Gduoi) (NAVs) tend to be lower than benchmarks because funds have fees, unlike the index itself. A high [expense ratio](https://www.investopedia.com/terms/e/expenseratio.asp) can significantly harm a fund's performance. Fund managers can offset high fees and outperform the index through effective [rebalancing](https://www.investopedia.com/terms/r/rebalancing.asp), dividend management, or securities lending.

Beyond fund fees, a number of other factors can affect a fund's tracking error. One important factor is the extent to which a fund's holdings match the holdings of the underlying index or benchmark. Funds often contain a sample of securities that managers believe represent the index. There are frequently also differences in weighting between a fund's assets and the assets of the index.

[Illiquid](https://www.investopedia.com/terms/i/illiquid.asp) or thinly traded securities can cause tracking errors due to significant price differences and large [bid-ask spreads](https://www.investopedia.com/terms/b/bid-askspread.asp). Finally, the level of volatility for an index can also affect the tracking error.

[Sector](https://www.investopedia.com/terms/s/sector-etf.asp#axzz1lc9Gduoi), [international](https://www.investopedia.com/terms/i/international-etf.asp#axzz1lc9Gduoi), and [dividend ETFs](https://www.investopedia.com/terms/d/dividend-etf.asp#axzz1lc9Gduoi) tend to have higher absolute tracking errors; broad-based equity and [bond ETFs](https://www.investopedia.com/terms/b/bond-etf.asp#axzz1lc9Gduoi) tend to have lower ones. [Management expense ratios](https://www.investopedia.com/terms/e/expenseratio.asp) (MER) are the most prominent cause of tracking error and there tends to be a direct correlation between the size of the MER and tracking error. But other factors can intercede and be more significant at times.

### Premiums and Discounts to Net Asset Value

[Premiums](https://www.investopedia.com/terms/p/premium.asp) or [discounts](https://www.investopedia.com/terms/d/discount.asp) to NAV may occur when investors bid the market price of an ETF above or below the NAV of its basket of [securities](https://www.investopedia.com/terms/s/security.asp#axzz1lc9Gduoi). Such divergences are usually rare. In the case of a premium, the authorized participant typically [arbitrages](https://www.investopedia.com/terms/a/arbitrage.asp) it away by purchasing securities in the ETF basket, exchanging them for ETF units, and selling the units on the stock market to earn a profit (until the premium is gone). Premiums and discounts as high as 5% have been known to occur, particularly for thinly traded ETFs.

### Optimization

When there are thinly traded stocks in the benchmark index, the ETF provider can't buy them without pushing their prices up substantially, so it uses a sample containing the more liquid stocks to proxy the index. This is called portfolio optimization.

### Diversification Constraints

ETFs are registered with regulators as mutual funds and need to abide by the applicable regulations. Of note are two diversification requirements: 75% of its assets must be invested in cash, government securities, and securities of other investment companies, and no more than 5% of the total assets can be invested in any one security. This can create problems for ETFs tracking the performance of a sector where there are a lot of dominant companies. 

### Cash Drag

Indexes don't have cash holdings, but ETFs do. Cash can accumulate at intervals due to [dividend](https://www.investopedia.com/terms/d/dividend.asp#axzz1lc9Gduoi) payments, overnight balances, and trading activity. The lag between receiving and reinvesting the cash can lead to a decline in performance known as [drag](https://www.investopedia.com/terms/p/performance_drag.asp). Dividend funds with high payout [yields](https://www.investopedia.com/terms/y/yield.asp#axzz1lc9Gduoi) are most susceptible.

### Index Changes

ETFs track indexes and when the indexes are updated, the ETFs have to follow suit. Updating the ETF [portfolio](https://www.investopedia.com/terms/p/portfolio.asp#axzz1lc9Gduoi) incurs transaction costs. And it may not always be possible to do it the same way as the index. For example, a stock added to the ETF may be at a different price than what the index maker selected.

### Capital-Gains Distributions

ETFs are more tax-efficient than mutual funds but have nevertheless been known to distribute [capital gains](https://www.investopedia.com/terms/c/capitalgain.asp) that are taxable in the hands of unitholders. Although it may not be immediately apparent, these distributions create a different performance than the index on an after-tax basis. Indexes with a high level of turnover in companies (e.g., [mergers](https://www.investopedia.com/terms/m/merger.asp#axzz1lc9Gduoi), [acquisitions](https://www.investopedia.com/terms/a/acquisition.asp#axzz1lc9Gduoi), and [spin-offs](https://www.investopedia.com/terms/s/spinoff.asp)) are one source of capital-gains distributions. The higher the turnover rate, the higher the likelihood the ETF will be compelled to sell securities at a profit.

### Securities Lending

Some ETF companies may offset tracking errors through [security lending](https://www.investopedia.com/terms/s/securitieslending.asp#axzz1lc9Gduoi), which is the practice of lending out holdings in the ETF portfolio to hedge funds for [short selling](https://www.investopedia.com/terms/s/shortselling.asp). The lending fees collected from this practice can be used to lower tracking error if so desired.

### Currency Hedging

International ETFs with currency hedging may not follow a benchmark index due to the costs of currency hedging, which are not always embodied in the MER. Factors affecting hedging costs include market volatility and interest-rate differentials, which impact the pricing and performance of forward contracts. 

### Futures Roll

[Commodity ETFs](https://www.investopedia.com/terms/c/commodity-etf.asp#axzz1lc9Gduoi), in many cases, track the price of a [commodity](https://www.investopedia.com/terms/c/commodity.asp#axzz1lc9Gduoi) through the [futures markets](https://www.investopedia.com/terms/f/futuresmarket.asp#axzz1lc9Gduoi), buying the contract closest to expiry. As the weeks pass and the contract nears expiration, the ETF provider will sell it (to avoid taking delivery) and buy the next month's contract. This operation, known as the "roll," is repeated every month. If contracts further from expiration have higher prices ([contango](https://www.investopedia.com/terms/c/contango.asp)), the roll into the next month will be at a higher price, which incurs a loss. Thus, even if the spot price of the commodity stays the same or rises slightly, the ETF could still show a decline. Vice versa, if futures further away from expiration have lower prices ([backwardation](https://www.investopedia.com/terms/b/backwardation.asp)), the ETF will have an upward bias. 

### Maintaining Constant Leverage

﻿Leveraged and inverse ETFs use [swaps](https://www.investopedia.com/terms/s/swap.asp#axzz1lc9Gduoi), forwards, and futures to replicate on a daily basis two or three times the direct or inverse return of a benchmark index. This requires rebalancing the basket of derivatives daily to ensure they deliver the specified multiple of the index's change each day.

> **Fast Fact**
>
> Tracking error and beta are different. Generally speaking, a portfolio may have less tracking error if it has a lower beta (since it will move closer to the broad market moves). However, this is not always the case.

## Comparing Ex-Post and Ex-Ante Tracking Errors

Ex-post tracking error, also known as realized tracking error, is a backward-looking measure. It provides a factual account of how closely the portfolio has tracked its benchmark over a specific period in the past. Ex-post tracking error is useful for performance evaluation, as it shows the actual deviation that occurred between the portfolio and its benchmark.

Ex-ante tracking error, on the other hand, is a forward-looking estimate that attempts to predict how much a portfolio might deviate from its benchmark in the future. This measure is typically calculated using risk models, factor analysis, and statistical techniques that consider the current portfolio composition. Ex-ante tracking error is most useful in [risk management](https://www.investopedia.com/terms/r/riskmanagement.asp) and portfolio construction.

Aside from the usefulness mentioned above, the key difference between these two types of tracking errors lie in their calculation methods. Ex-post uses actual historical returns, while ex-ante uses predictive models and current portfolio characteristics. For this reason, it may be easier to get ex-post data as that is based on actuals; in order to determine an ex-ante tracking error, you have to come up with the future data yourself.

## Best Tools for Tracking Error Analysis

A variety of tools and software solutions are available for analyzing tracking error depending on your size and need.

At the most basic level for **retail investors** or **recreational investors**, spreadsheet applications like Microsoft Excel or Google Sheets can be used to calculate tracking error. You'd have to manually input portfolio and benchmark returns, but you can leverage spreadsheet formulas to compute both ex-post tracking error and basic ex-ante estimates.

More advanced options for [**sophisticated investors**](https://www.investopedia.com/terms/s/sophisticatedinvestor.asp) or **day traders** include specialized financial software packages such as Morningstar Direct or through a Bloomberg Terminal. These platforms offer automated data feeds, pre-built analytics tools, and customizable reporting where you can set up your portfolio and the tracking errors are calculated for you.

For [**institutional investors**](https://www.investopedia.com/terms/i/institutionalinvestor.asp) and large asset managers, there are more sophisticated risk management and portfolio analytics systems like BlackRock's Aladdin, MSCI Barra, or Axioma. These platforms provide advanced modeling capabilities. These types of platforms often integrate with trading systems and can provide real-time analytics.

## Example of Calculating Tracking Error

Assume that there is a [large-cap](https://www.investopedia.com/terms/l/large-cap.asp) mutual fund benchmarked to the S&P 500 index. Next, assume that the mutual fund and the index realized the following returns over a given five-year period:

*   Mutual Fund: 11%, 3%, 12%, 14% and 8%.
*   S&P 500 index: 12%, 5%, 13%, 9% and 7%.

Given this data, the series of differences is then (11% - 12%), (3% - 5%), (12% - 13%), (14% - 9%) and (8% - 7%). These differences equal -1%, -2%, -1%, 5%, and 1%. The standard deviation of this series of differences, the tracking error, is 2.50%.

## What Is a Tracking Error?

Tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. It is defined as the standard deviation of the difference between the portfolio and index returns over time.

## How Do You Calculate Tracking Error?

Tracking error is calculated by taking the standard deviation of the difference between the portfolio returns and the benchmark returns over a specified period. First, you calculate the difference in returns for each period (often daily or monthly). Then, you find the average of these differences. Finally, you calculate the standard deviation of these differences. The resulting figure represents the tracking error, typically expressed as a percentage.

## What Causes Tracking Errors?

Several factors can contribute to tracking errors. These include transaction costs, management fees, cash drag (such as uninvested cash in the portfolio), differences in portfolio composition compared to the index, timing of rebalancing, dividend reinvestment policies, and corporate actions like mergers or spin-offs.

## Why Does Tracking Error Matter?

Tracking error is important because it provides investors with a measure of how well an index fund or ETF is replicating its benchmark. A low tracking error suggests that the fund is achieving its goal of mimicking the index, which is important for passive investment strategies.

## The Bottom Line

Tracking error is a measure of how closely a portfolio follows its benchmark index, typically calculated as the standard deviation of the difference between the portfolio and index returns over time. It's crucial for evaluating the performance of index funds and ETFs, with lower tracking errors indicating better replication of the benchmark. 

Tracking errors may arise due to management fees, rebalancing, or variations in fund strategy. Whatever the cause, it can provide valuable insights into fund performance and estimates of future risk.

> **Article Sources**
>
> 1.  U.S. Government Publishing Office. "[Investment Act of 1940](https://www.govinfo.gov/content/pkg/COMPS-1879/pdf/COMPS-1879.pdf)," Page 24.