What does tracking error measure?

Tracking error measures the deviation of an investment fund's returns from its benchmark. This concept is important because it quantifies how closely the performance of a portfolio aligns with that of its benchmark index.

When an investment manager aims to replicate the performance of a benchmark—such as an index fund tracking the S&P 500—the tracking error helps assess the effectiveness of that strategy. A low tracking error indicates that the fund closely follows the benchmark's returns, suggesting that the manager is successfully mirroring the benchmark's performance, while a high tracking error implies significant deviation, which could be due to active management decisions or an inability to replicate index performance.

Understanding tracking error is crucial for investors who wish to evaluate the risk associated with a fund relative to its benchmark, providing insights into the level of risk assumed by the manager in pursuit of excess returns. This analysis helps investors decide whether it aligns with their investment objectives, risk tolerance, and performance expectations.