CandleFocus Glossary Editor
Tracking error is an important concept for investors to understand, as it reveals how closely a portfolio adheres to its benchmark. This is a vital tool for measuring portfolio risk and performance, as it determines how reliably a fund tracks the performance of its benchmark index. A fund with a lower tracking error implies a manager is allocating a portfolio closer to the benchmark, while a fund with a higher tracking error implies the manager is making more active decisions.
At its core, tracking error is the difference between the return of a fund or portfolio and its benchmark. Although tracking error can be used to compare any two funds, or portfolios, it is particularly useful when one of the funds is an index. As an example, a fund tracking the S&P 500 index will have a lower tracking error than an actively managed fund due to the passive nature of the S&P 500, while the actively managed fund will be making more varied investment decisions and therefore demonstrate higher tracking error.
When measuring tracking error, one should consider the size of the difference in returns. A larger tracking error means the portfolio has underperformed or outperformed its benchmark to a greater degree. Investors should also consider the size of the benchmark index’s periodic returns relative to the return of the portfolio itself. For example, if the portfolio has a return of 6%, while the benchmark index has a return of 4%, then the tracking error is 2%.
It is important to note that the higher the tracking error of a fund, the greater its risk level. If a portfolio manager exhibits greater tracking error, this most likely means he or she is making a larger number of investment decisions that deviate from its benchmark; this also means greater potential for greater returns or losses. It is therefore beneficial for investors to study the past performance of portfolio managers and their respective benchmark indexes to gain insight into their risk management strategy.
In a nutshell, tracking error is a powerful tool used by investors to measure the degree to which a portfolio deviates from its given benchmark index. By examining the tracking error of a fund, investors can gain an understanding of the level of risk they are facing and the potential that their portfolio manager is actively pursuing various strategies to outperform the benchmark.
At its core, tracking error is the difference between the return of a fund or portfolio and its benchmark. Although tracking error can be used to compare any two funds, or portfolios, it is particularly useful when one of the funds is an index. As an example, a fund tracking the S&P 500 index will have a lower tracking error than an actively managed fund due to the passive nature of the S&P 500, while the actively managed fund will be making more varied investment decisions and therefore demonstrate higher tracking error.
When measuring tracking error, one should consider the size of the difference in returns. A larger tracking error means the portfolio has underperformed or outperformed its benchmark to a greater degree. Investors should also consider the size of the benchmark index’s periodic returns relative to the return of the portfolio itself. For example, if the portfolio has a return of 6%, while the benchmark index has a return of 4%, then the tracking error is 2%.
It is important to note that the higher the tracking error of a fund, the greater its risk level. If a portfolio manager exhibits greater tracking error, this most likely means he or she is making a larger number of investment decisions that deviate from its benchmark; this also means greater potential for greater returns or losses. It is therefore beneficial for investors to study the past performance of portfolio managers and their respective benchmark indexes to gain insight into their risk management strategy.
In a nutshell, tracking error is a powerful tool used by investors to measure the degree to which a portfolio deviates from its given benchmark index. By examining the tracking error of a fund, investors can gain an understanding of the level of risk they are facing and the potential that their portfolio manager is actively pursuing various strategies to outperform the benchmark.