Definition of Tracking Error
How Tracking Error Works
Tracking Error vs. Tracking Difference
What It Means for Individual Investors
Definition of Tracking Error
Tracking error is the difference between the performance of a portfolio and the performance of its benchmark index over time. Tracking error is the difference between the portfolio’s returns and the index’s returns. Index funds have low tracking error while actively managed funds have high tracking error. The tracking difference is the difference in returns over a specific time period between a portfolio and its index, while tracking error shows how often the portfolio’s returns deviate from the index.
How Tracking Error Works
Let’s use Exchange Traded Funds (ETFs) to illustrate how tracking error works. We will use the SPDR S&P 500 ETF (SPY) as an example of an index fund and the ARK Innovation ETF (ARKK) as an example of an actively managed fund.
SPY is an S&P 500 index fund. It aims to replicate the S&P 500 and is passively managed. Any tracking error it has is essentially friction on your investments over time. In its prospectus, the fund manager notes that fees and expenses can create imperfect correlation between the fund’s performance and its index.
According to Fidelity, the tracking error of SPY in August 2021 is only 0.03. The median for its asset class is 10.41, meaning that the standard deviation of the actual return differences between SPY and the S&P 500 is low compared to other ETFs with the same stocks.
ARKK is an actively managed fund. According to its prospectus, ARKK seeks to invest in companies it considers involved in disruptive innovation. It makes sense that these companies would not have the same return trends as an index made up of more stable stocks.
Thus, the tracking error for ARKK was 34.71 in August 2021, more than three times the median figure. Again, this makes sense. If you are paying (and the expense ratio for ARKK at 0.75% is much higher than 0.09% for SPY) for an actively managed fund, you wouldn’t want to have the same tracking error as a passively managed fund like SPY.
Tracking Error vs. Tracking Difference
Both tracking error and tracking difference can be used to analyze funds. While tracking error shows how often and by how much the portfolio deviates from the index, tracking difference is simply the difference in returns over a certain time period.
It is possible for a fund to have a high tracking error and a low tracking difference if its returns frequently differ from the index but end up around the same value at the end of the period.
What It Means for Individual Investors
You can use tracking error to analyze a new fund or to ensure that your current investment is doing what it should. If you are looking for an index fund to diversify your portfolio, make sure it has a low tracking error so you do not sacrifice your returns due to costs. If you are paying more for an actively managed fund to try to outperform the market, you wouldn’t want a low tracking error because you could simply buy an index fund and theoretically achieve the same result.
Source: https://www.thebalancemoney.com/what-is-tracking-error-5198440
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