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.
Where n is the number of periods over which the returns are tracked.
Tracking error is an important measure for investors to know how well the portfolio is replicating the index. A low tracking error indicates the portfolio is closely following the benchmark. A high tracking error means the portfolio is moving away from the benchmark index. Investors desire a low tracking error.