Tracking Error
The standard deviation of the difference between a portfolio's returns and its benchmark.
What is Tracking Error?
Tracking error measures how closely a portfolio follows its benchmark index, calculated as the standard deviation of the return differences (active returns) between the portfolio and the benchmark over time. A low tracking error (near 0%) means the portfolio closely mirrors the index — typical for index funds. A high tracking error indicates large active bets. Index ETFs typically have tracking errors below 0.10%, while active funds may have tracking errors of 3%–8%. Lower is generally preferred for passive strategies.
Example
An S&P 500 index ETF with 0.04% tracking error closely replicates the index. An active large-cap fund with 6% tracking error takes substantial bets away from the benchmark — each requiring superior stock selection to add value.