Tracking error measures the consistency of a fund's returns relative to its benchmark index. It is calculated as the standard deviation of the differences between the fund's returns and the benchmark's returns over a series of periods. A low tracking error indicates that the fund closely mirrors the benchmark, while a high tracking error suggests significant deviation from the index's performance.

The annualized tracking error is derived by multiplying the monthly tracking error by the square root of 12, scaling the monthly figure to an annual equivalent. For a well-managed S&P 500 index fund, annualized tracking error is typically less than 0.10%, meaning the fund's annual return rarely deviates from the index by more than a tenth of a percent. Actively managed funds, by contrast, often have tracking errors of 3-8% or more by design.

The information ratio divides the mean active return by the tracking error, measuring whether any deviation from the benchmark is rewarded with higher returns. An information ratio above 0.5 is generally considered good, above 1.0 is excellent, and values near zero suggest the fund's deviation from the benchmark is not generating meaningful excess returns. For passive index funds, the information ratio is less relevant since the goal is to minimize tracking error rather than generate alpha.