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How tightly your portfolio shadows the benchmark.
Tracking error is the standard deviation of the difference between portfolio returns and benchmark returns. It measures how tightly a portfolio shadows its benchmark. A tracking error of 1% means returns tend to be within ±1% per year of the benchmark; 10% means the portfolio frequently deviates substantially. Index funds aim for near-zero tracking error.
TE = σ(Rp − Rb)TE = σ(Rp − Rb)Compute the active return for each period (portfolio minus benchmark). Take the standard deviation. Annualize.
Tracking error is the denominator of the Information Ratio — it measures the volatility of the active bet. A fund claiming to be active but with sub-1% tracking error is closet indexing: charging active fees for passive performance.
Monthly active returns for the past 36 months had standard deviation of 1.5%. Annualized: 1.5% · sqrt(12) = 5.2%
That is typical for an active equity manager.
Tracking error by strategy type:
| Tracking Error | Strategy |
|---|---|
| 0 – 0.5% | Pure index funds. Should be this low. |
| 0.5 – 1% | Closet indexer. Active label, passive behavior. |
| 1 – 3% | Mildly active equity managers. |
| 3 – 8% | Typical active equity, sector funds. |
| 8 – 15% | Concentrated strategies, thematic ETFs. |
| > 15% | Long/short, high-conviction or leveraged. |
Depends on the strategy. For an index fund, low is good (<1%). For an active manager, you want positive Information Ratio — i.e. active return is producing more than tracking error costs.
Not necessarily — it just means the portfolio takes large bets vs. the benchmark. Whether that is good depends on whether the bets pay off (see Information Ratio).
Beta measures sensitivity to benchmark moves. Tracking error measures the size of deviations from the benchmark. A portfolio can have high beta but low tracking error (leveraged index fund) or vice versa.
Yes — against the S&P 500 and other benchmarks. Used in the Information Ratio calculation.
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