What is Tracking Error
Tracking error is a measure of how closely a portfolio follows its benchmark. A tracking error of zero means that the portfolio exactly follows its benchmark. The benchmark could be an index such as S\&P 500 index. Let’s say the S\&P 500 index provides a return of 6% and your portfolio tracking the S\&P 500 index earns 4% returns. The tracking error is calculated as follows:
Tracking Error = Rp - Ri
p = portfolio
i = index or benchmark
In our example, the tracking error will be:
Tracking error = 4% - 6% = -2%
Morningstar defines tracking error as trailing returns.
Tracking Risk: Tracking error sometimes also refers to tracking risk, which is the standard deviation of returns of the portfolio to benchmark returns over a period of time. This is a more commonly used method of calculating tracking error.
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