Tracking Error: Variation, Not Shortfall
Tracking error measures the variability of a fund's return difference from its benchmark — how much that gap moves about, not how large it is. The average size of the gap is tracking difference, and for an index fund that second figure is the one that costs you money.
How it works
Take the fund’s return and the index’s return over the same periods, and subtract. That series of differences is what the measure describes — not any single one of them.
It is the standard deviation of that series. A fund that trails its index by the same amount every month has a small tracking error, because the gap barely varies — even though the gap itself may be substantial.
The average of the differences is tracking difference, and it is the number that costs you. The two are routinely confused, including in fund marketing. A low tracking error with a large tracking difference is a fund that is reliably behind — which is worse, not better.
Four things produce the gap. The ongoing charge, deducted continuously. Sampling, where the fund holds a representative subset rather than every constituent. Cash held for redemptions, which is not invested. And withholding tax on dividends, which the index calculation may ignore.
What a good figure looks like depends on the fund
For a tracker, matching the index is the entire product. A large tracking error means the fund is not doing the one thing it was bought to do, whichever direction the deviation runs.
For an active fund the reverse holds. A manager charging active fees while producing a very small tracking error is delivering an index at a premium — the situation sometimes called closet indexing, and it is visible in this statistic before it is visible anywhere else.
So the same number is good or bad depending on what was promised. It is a measure of difference, and whether difference is a defect is a question about the mandate.
In practice
The charge is the component you can know in advance. On this site’s arithmetic, compounding the fee alone over thirty years, 5 basis points removes 1.5% of the pot and 75 basis points removes 20.2% — and that is before any question of how well the index was tracked.
Sampling is a liquidity decision. A broad index contains constituents too small or too thinly traded to buy efficiently, so the fund approximates them — and the approximation shows up here.
A short measurement period tells you very little. The statistic needs enough observations to be stable, and comparing funds over different windows compares different things.
Index changes are the stress test. When constituents are added or removed on a known date, every tracker must trade the same names at the same time, and the deviation shows up in that period.
It says nothing about risk of loss. A fund can track a falling index perfectly, and a stop is not part of this conversation at all.
Switching funds has a price too. Selling one fund and buying another crosses a spread twice and may carry a commission, plus any tax on the disposal — so a small improvement in tracking rarely pays for the move.
How to compare two trackers honestly
Start with the tracking difference over five years, not the tracking error. How far behind the index did the fund actually finish, on average, per year. That figure is what you paid, and it should be close to the ongoing charge.
If it is much larger than the fee, ask why. Sampling, tax treatment or cash drag will explain it, and a fund that cannot explain it is one to avoid. If it is smaller than the fee, ask that too — securities lending income can legitimately close the gap, and it carries a risk the fund should disclose.
Only then look at the variability. It matters if you are matching a liability on a date, and it matters much less if you are holding for twenty years and only the endpoint counts.
What tracking error is not
It is not the shortfall. That is tracking difference.
It is not a risk measure. The index can fall too.
It is not always bad. Active funds should have it.
And a low figure is not a cheap fund. Check the difference.
How this connects
Active risk is the same statistic under another name, used when the benchmark belongs to a fund manager who is supposed to deviate rather than to a tracker.
Alpha is the figure that goes on top of it. Dividing active return by tracking error gives the information ratio, which asks whether the deviation from the index was worth taking.
The expense ratio is where tracking difference starts, and a fund factsheet usually shows the charge and the tracking figures close together.
Some funds deviate by design. A leveraged ETF targets a multiple of one day’s index return, so over longer periods its result can differ widely from that multiple, which is compounding rather than poor tracking.
A closed-end fund adds a second gap. Its share price can sit at a discount to NAV, so the return an investor receives can differ from the portfolio’s even when the portfolio tracks well.
Harder indices track worse. A bond index or a basket of international stocks usually carries wider gaps, because some constituents trade rarely and tax on foreign dividends varies by country.
And factor investing sits in between. A factor fund measured against the broad market shows sizeable tracking error on purpose, and its tracking quality belongs against its own factor index.
When it fails
In a flat market the whole gap is the charge. Nothing else is moving, so the fund’s shortfall is its cost — which makes a sideways period the clearest read on what a fund is really taking.
The second failure is choosing on tracking error alone. The steadiest laggard wins that contest.
A third is comparing figures over different periods. The statistic is not portable between windows.
A fourth is ignoring what the index itself measures. Two funds tracking similar-sounding indices are not comparable at all.
A fifth is expecting perfect tracking from a sampled fund. It was never going to hold everything.
And a sixth is switching for a marginal improvement. The trading cost and any tax usually exceed it.
The original data
Of the 24,971 videos in the search study behind this site, 2 have “tracking error” in the title, at a median of 20,003 views across 2 channels, with a maximum of 39,809. “Index fund” appears in 132 at a median of 69,951. One video, one count, no matter how many of the searches happened to return it.
The question: The fund lagged its index again. Switch?
Two videos, and the median audience for them is 20,003. Index funds are among the most-covered products in this corpus and the measurement of whether one is doing its job appears twice. That pattern recurs across this whole site: the product is taught, the diagnostic is not.
The answer to that final question is usually no, and the fee arithmetic says why. A tracker lagging its index by roughly its charge is working exactly as designed. Compare the five-year tracking difference against the ongoing charge before considering a switch — if they are close, the fund is fine and the trading cost of moving is a certain loss against an uncertain gain.
Related
Index funds is the product this measures and where the fee comparison belongs. Exchange-traded fund investing covers the exchange-listed version and its own tracking quirks. And beta is the neighboring statistic people most often confuse this one with.
I do not choose a fund on tracking error alone. The fund with the most consistent shortfall is not the one that costs you least, because steadier can mean reliably a bit further behind. Consistency is a nice property and it is not the property you are paying for.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.