what is a tracking error 
tracking error is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark this is often in the context of a hedge fund mutual fund or exchange traded fund etf that did not work as effectively as intended creating an unexpected profit or loss 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 they were attempting to imitate investopedia julie bangunderstanding a tracking errorsince 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 even portfolios that are perfectly indexed against a benchmark behave differently than the benchmark even though this difference on a day to day quarter to quarter or year to year basis may be ever so slight 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 given a sequence of returns for an investment or portfolio and its benchmark tracking error is calculated as follows from an investor s point of view tracking error can be used to evaluate portfolio managers if a manager is realizing low average returns and has a large tracking error it is a sign that there is something significantly wrong with that investment and that the investor should most likely find a replacement 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 special considerationsthe net asset value nav of an index fund is naturally inclined toward being lower than its benchmark because funds have fees whereas an index does not a high expense ratio for a fund can have a significantly negative impact on the fund s performance however it is possible for fund managers to overcome the negative impact of fund fees and outperform the underlying index by doing an above average job of portfolio rebalancing managing dividends or interest payments 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 many funds are made up of just the fund manager s idea of a representative sample of the securities that make up the actual index there are frequently also differences in weighting between a fund s assets and the assets of the index illiquid or thinly traded securities can also increase the chance of a tracking error since this often leads to prices differing significantly from market price when the fund buys or sells such securities as a result of larger bid ask spreads finally the level of volatility for an index can also affect the tracking error sector international and dividend etfs tend to have higher absolute tracking errors broad based equity and bond etfs tend to have lower ones management expense ratios 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 or discounts to nav may occur when investors bid the market price of an etf above or below the nav of its basket of securities such divergences are usually rare in the case of a premium the authorized participant typically arbitrages 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 