# Finance Terms: Tracking Error

As investors, it is important to have a solid grasp of key finance terms, such as tracking error. Understanding what tracking error is and how it impacts investment performance can help us make informed investment decisions. In this article, we will provide a comprehensive guide to tracking error, including its calculation, interpretation, real-life examples, and more.

## Understanding the Basics of Tracking Error

Tracking error is a measure of the deviation of an investment fundâ€™s returns from its benchmark index. It is how much the fundâ€™s return differs from the return of the benchmark it is trying to match. Tracking error is expressed as a percentage and is calculated by taking the standard deviation of the difference between the fundâ€™s returns and the benchmark returns.

Investors can use the tracking error as an indicator of how well a fund is tracking its benchmark. Funds with low tracking error are generally considered to be better performers than those with high tracking error.

It is important to note that tracking error is not the same as fund performance. A fund can have a high tracking error but still outperform its benchmark. This can happen if the fund takes on more risk than the benchmark, resulting in higher returns. Conversely, a fund can have a low tracking error but underperform its benchmark if it is too conservative in its investments.

## How Tracking Error is Calculated

Tracking error is calculated by taking the standard deviation of the difference between the fundâ€™s returns and the benchmark returns. The standard deviation measures the amount of dispersion, or variability, of a set of numbers. In this case, it is measuring the variability of the difference between the fund returns and the benchmark returns.

This is expressed using the following formula:

`Tracking Error = Standard Deviation of (Fund Returns - Benchmark Returns)`

Tracking error is usually calculated over a period of one year or more. The longer the period, the more accurate the tracking error measure is likely to be.

It is important to note that tracking error is not the same as the fundâ€™s performance. A fund can have a high tracking error but still outperform its benchmark, or vice versa. Tracking error simply measures how closely the fund is tracking its benchmark.

Investors use tracking error as a way to evaluate the performance of a fund manager. A high tracking error may indicate that the manager is taking on more risk than necessary, while a low tracking error may indicate that the manager is not taking enough risk to generate returns that are significantly different from the benchmark.

## The Importance of Tracking Error in Investment Management

Tracking error is an important metric in investment management because it measures how well a fund is tracking its benchmark. It is especially critical in passive investing strategies, such as index investing, where the goal is to match the performance of a specific index as closely as possible.

A high tracking error can indicate that the fund is not performing well in comparison to its benchmark. This could be due to a number of factors, such as high expenses, inefficient trading, or a portfolio that is poorly diversified. On the other hand, a low tracking error suggests that the fund is closely tracking its benchmark, which is a good sign for investors.

It is important to note that tracking error should not be the only metric used to evaluate the performance of a fund. Other factors, such as the fund’s risk-adjusted returns, expense ratio, and overall investment strategy, should also be taken into consideration. Additionally, tracking error may not be as relevant for actively managed funds, where the goal is to outperform the benchmark rather than match it.

## Common Causes of Tracking Error

Tracking error can be caused by a variety of factors, such as:

• Expenses: High fees and expenses can reduce the fund’s returns and increase its tracking error.
• Trading costs: Poorly timed trades or transactions with high commissions can also impact tracking error.
• Portfolio composition: If the holdings in the fund are not representative of the benchmark, it can lead to tracking error, such as when a fund is over or underweight in certain sectors.
• Rebalancing: The process of rebalancing the portfolio back to its original weights in the benchmark can also cause tracking error.

Another common cause of tracking error is market volatility. When the market experiences sudden and unexpected changes, it can cause the fund’s returns to deviate from the benchmark. This can be especially true for funds that track more volatile markets, such as emerging markets or small-cap stocks. Additionally, changes in market conditions, such as interest rate fluctuations or geopolitical events, can also impact tracking error.

## Mitigating Tracking Error through Portfolio Diversification

One way to reduce tracking error is through portfolio diversification. By investing in a broad range of assets, investors can spread their risks and reduce the impact of any one asset on the overall portfolio. This can help to ensure that the portfolio remains representative of the benchmark and can therefore result in lower tracking error.

However, it is important to note that diversification alone may not completely eliminate tracking error. Other factors such as transaction costs, market volatility, and liquidity can also contribute to tracking error. Therefore, it is important for investors to regularly monitor and adjust their portfolios to ensure that they continue to align with their investment objectives and minimize tracking error.

## How to Interpret Tracking Error in Investment Performance

Interpreting tracking error requires an understanding of the context in which it is being used. A high tracking error could mean the fund is deviating significantly from its benchmark, which could indicate poor performance. However, it could also mean that the fund is taking active bets on certain assets outside the benchmark that are performing well.

On the other hand, a low tracking error means the fund is closely tracking its benchmark, which suggests that the manager is following a more passive strategy. Again, this may not be a bad thing if the goal of the strategy is to achieve returns that are close to the benchmark.

It is important to note that tracking error should not be the only factor considered when evaluating investment performance. Other factors such as fees, risk, and overall returns should also be taken into account. Additionally, tracking error can vary depending on the time period being analyzed, so it is important to look at long-term trends rather than short-term fluctuations.

Investors should also consider their own investment goals and risk tolerance when evaluating tracking error. A higher tracking error may be acceptable for investors who are willing to take on more risk in pursuit of higher returns, while a lower tracking error may be more suitable for investors who prioritize stability and consistency in their investments.

## Real Life Examples of Tracking Error in Investment Funds

For example, letâ€™s assume an investor invests in a fund that tracks the S&P 500 index and is given a target of +/- 1% for its tracking error. If the fund has a tracking error of -0.5%, this means that the fund has underperformed the benchmark by 0.5%. If, on the other hand, the tracking error was 1.5%, the fund would be outperforming the benchmark by 1.5%.

Another real-life example of tracking error in investment funds is when a fund manager tries to replicate the performance of a specific sector or industry. If the fund manager invests in a limited number of stocks within that sector, the fund’s performance may deviate from the benchmark due to the lack of diversification. This can result in a higher tracking error.

Furthermore, tracking error can also be affected by external factors such as market volatility, changes in interest rates, and geopolitical events. For instance, during a market downturn, a fund that tracks the S&P 500 index may experience a higher tracking error due to the increased volatility in the market.

## The Impact of Market Volatility on Tracking Error

Volatility can have a significant impact on tracking error. During periods of high market volatility, a portfolio may experience significant fluctuations in value. This can result in a higher tracking error as the returns of the fund diverge more significantly from those of the benchmark. Conversely, during periods of low volatility, the tracking error is likely to be lower as the returns of the fund are more closely aligned with those of the benchmark.

It is important to note that tracking error is not always a negative thing. In fact, some active fund managers intentionally aim for a higher tracking error in order to generate higher returns. This strategy is known as active share and involves deviating from the benchmark in order to take advantage of market inefficiencies and generate alpha.

However, it is also important to keep in mind that a high tracking error can also indicate poor portfolio management or a lack of diversification. Investors should carefully consider the level of tracking error when selecting a fund and ensure that it aligns with their investment goals and risk tolerance.

## The Role of Professional Fund Managers in Managing Tracking Error

Professional fund managers play a key role in managing tracking error. They use a variety of strategies to try to minimize tracking error and to ensure the fund is closely tracking its benchmark. These strategies may include diversifying the portfolio, minimizing trading costs, and rebalancing the portfolio on a regular basis.

In addition to these strategies, professional fund managers also closely monitor market trends and adjust the portfolio accordingly. They may also use advanced risk management techniques to mitigate the impact of unexpected market events on the fund’s performance. By constantly analyzing and adjusting the portfolio, fund managers aim to provide investors with consistent returns that closely match the benchmark, while also managing risk.

## How to Use Tracking Error to Evaluate Investment Funds

Tracking error is a useful metric for evaluating investment funds. Investors can use tracking error to compare the performance of different funds that track the same benchmark. A lower tracking error suggests that a fund is performing better than one with a higher tracking error.

However, investors need to consider other factors when evaluating funds, such as fund expenses, historical performance, and risk. It is important to evaluate funds in the context of an individualâ€™s investment objectives and risk tolerance.

Another important factor to consider when evaluating investment funds is the fund managerâ€™s investment strategy. Some managers may have a more aggressive investment approach, while others may be more conservative. It is important to understand the managerâ€™s strategy and how it aligns with your investment goals.

## Limitations of Tracking Error as a Performance Metric

While tracking error is a useful metric, it has limitations. Tracking error only measures the deviation from a benchmark index and does not consider the absolute performance of the fund. Therefore, it should be used in conjunction with other performance metrics to get a more comprehensive picture of the fundâ€™s performance.

Another limitation of tracking error is that it does not take into account the risk level of the fund. A fund with a high tracking error may be taking on more risk than a fund with a lower tracking error, which could lead to higher returns but also higher losses. Therefore, investors should also consider the risk-adjusted performance of the fund when evaluating its performance.

Additionally, tracking error may not be an appropriate metric for all types of funds. For example, actively managed funds may have higher tracking error than passively managed funds, as they are designed to deviate from the benchmark index. In these cases, investors may need to consider other metrics, such as alpha and beta, to evaluate the fundâ€™s performance.

## Measuring and Minimizing Tracking Errors with ETFs

Exchange-traded funds (ETFs) are a popular investment vehicle that can be used to minimize tracking error. Since ETFs are designed to track specific indices, they can reduce tracking error significantly compared to actively managed funds. Additionally, ETFs often have lower expense ratios, which can help improve overall fund performance.

However, it is important to note that not all ETFs are created equal. Some ETFs may have higher tracking errors than others, which can lead to underperformance compared to the index they are tracking. It is important to carefully research and compare different ETFs before investing to ensure that you are selecting the one with the lowest tracking error and highest potential for performance.

## Best Practices for Managing and Analyzing Tracking Errors

Finally, some best practices for managing and analyzing tracking error include:

• Defining an appropriate benchmark index
• Establishing a target level of tracking error
• Monitoring the fundâ€™s performance on a regular basis
• Adjusting the portfolio as needed to stay aligned with the benchmark
• Considering other factors, such as expenses and risk, when evaluating the fundâ€™s overall performance

By following these best practices, investors can effectively manage and analyze tracking error to make informed investment decisions.

One important factor to consider when managing tracking error is the level of diversification in the portfolio. A well-diversified portfolio can help to reduce tracking error by spreading out risk across multiple asset classes and sectors. Additionally, investors should consider the impact of market volatility on tracking error, as sudden market movements can cause tracking error to increase.

Another best practice for managing tracking error is to regularly review and update the benchmark index used to measure the fundâ€™s performance. As market conditions and investment strategies change over time, it may be necessary to adjust the benchmark to ensure that it remains relevant and accurate.

## Conclusion

Tracking error is an important metric in investment management. It measures the deviation of a fundâ€™s returns from its benchmark and is used to evaluate how well the fund is tracking its benchmark index. By understanding the calculation, interpretation, and key factors that impact tracking error, investors can make informed investment decisions and manage their portfolios more effectively.

One of the key factors that can impact tracking error is the level of active management within a fund. Funds that are actively managed tend to have higher tracking error as the fund manager may make investment decisions that deviate from the benchmark index. On the other hand, passively managed funds, such as index funds, tend to have lower tracking error as they aim to replicate the performance of the benchmark index.

Another factor that can impact tracking error is the level of diversification within a fund. Funds that are highly concentrated in a particular sector or asset class may have higher tracking error as they are more exposed to the performance of that sector or asset class. Conversely, funds that are well-diversified across multiple sectors and asset classes may have lower tracking error as they are less reliant on the performance of any one particular area of the market.