TrackingError

TrackingError is a measure used in portfolio management to quantify how closely a portfolio follows the performance of its benchmark. It is defined as the standard deviation of the difference between the portfolio’s returns and the benchmark’s returns over a chosen period. In formula terms, TE = stdev(Rp - Rb), where Rp is the portfolio return and Rb is the benchmark return. The difference Rp - Rb is often referred to as the active return.

Low tracking error indicates that the portfolio behaves similarly to the benchmark, which is typical for passive or index-like strategies. Higher tracking error signals more active management and greater deviation from the benchmark, reflecting the level of active risk or skill attributed to the portfolio manager.

Tracking error is usually calculated on a periodic return series such as daily or monthly returns. It can also be estimated ex ante using the covariance of portfolio and benchmark returns or via a factor-model approach. The value of TE depends on the selected time horizon and data frequency.

Relation to active return and risk: Active return equals Rp - Rb, while tracking error is the risk or volatility of that active return. A portfolio might exhibit a high tracking error yet still underperform the benchmark on average, so TE is a risk measure rather than a performance measure.

Limitations and considerations: Tracking error does not indicate the direction of deviation, nor whether the manager adds value. It is sensitive to benchmark choice and data timing and can be distorted by infrequent rebalancing or data issues. It should be used alongside other metrics.

Applications: Tracking error informs risk budgeting, performance attribution, mandate design, and monitoring of active risk. It complements measures such as the information ratio and the level of active risk an investment seeks to assume.