Tracking Error
What is Tracking Error?
Tracking error is a financial measure that shows how much an investment portfolio's returns differ from the returns of a benchmark index. It’s commonly used for index funds, ETFs, and other passively managed funds to check how well they mimic their benchmark’s performance.
Why is Tracking Error Important?
Understanding Risk: A big tracking error means the fund’s returns are more unpredictable compared to the benchmark, which could mean higher risk.
Cost Awareness: Funds with low tracking errors often have lower fees and costs, making them a budget-friendly choice for investors.
Aligning with Your Goals: Knowing the tracking error helps you decide if a fund fits your strategy - whether you want steady returns that mirror an index or you’re okay with taking more risks for potentially higher gains.
What Affects Tracking Error?
Portfolio Size: Funds holding more stocks from the benchmark index usually have lower tracking errors. Adding stocks not in the benchmark increases the chances of performance differences.
Stock Types: Differences in stock size (large-cap vs. small-cap) or style (growth vs. value) compared to the index can cause mismatched returns.
Sector Allocation: If a fund invests heavily in one sector while the benchmark is more balanced, performance can differ.
Market Volatility: When markets are unstable, a fund’s returns may swing more than the benchmark’s, increasing tracking error.
Trading Costs: Fees like commissions and bid-ask spreads can lower returns and widen the gap from the benchmark.
Management Fees: Higher operational costs eat into returns, making it harder for a fund to match its benchmark.
Cash Drag: Holding too much cash can slow down reinvestments, causing underperformance.
Index Changes: When the benchmark index updates its stocks, funds need time to catch up, creating temporary mismatches.
Corporate Events: Events like mergers or stock splits can affect stocks differently in the portfolio and the index.
Currency Fluctuations: For international funds, changes in exchange rates can impact returns compared to a benchmark in a different currency.
