Definition
Tracking error measures how closely a portfolio follows its benchmark. Low tracking error (1-2%) indicates close benchmark tracking (index funds). Higher tracking error (5-10%) indicates active deviation from the benchmark. It is the denominator of the information ratio and a key risk parameter for institutional investors with tracking error budgets.
functions Formula
TE = StdDev(Rp − Rb)
lightbulb Example
An active equity fund has monthly return differences vs S&P 500 of: +0.3%, -0.2%, +0.5%, -0.1%, +0.4%, -0.3%... Annualized tracking error ≈ 3.5%. The fund deviates meaningfully from the index.
verified_user Key Points
- Low TE = close to benchmark (index-like)
- High TE = significant active risk
- Denominator of information ratio
- Institutional investors set TE budgets for managers