Definition
Tracking difference is the signed gap between a fund's return and its benchmark's return over a stated period, found by subtracting the benchmark return from the fund return. A negative value means the fund lagged the benchmark and a positive value means it exceeded it.
How it works
For a passive fund the figure over a year is usually negative, mainly because of the expense ratio and trading costs. It can be partly offset by securities-lending income, and it is also affected by sampling of holdings, cash held for flows, timing differences and the tax treatment of dividends compared with the index's assumptions.
Tracking difference shows how far ahead or behind the fund ended up; tracking error shows how much the gap varied along the way. Compare like with like: total returns, over the same dates and in the same currency, and say whether NAV or market price was used.
Formula / convention
Tracking difference = Fund return − Benchmark return (same period, same currency)
Illustrative example
Illustration with fictional figures: over one year a fictional ETF's NAV total return is 7.60% while its index's total return is 8.00%, so the tracking difference is 7.60% − 8.00% = −0.40 percentage points. With an expense ratio of 0.30%, fees explain 0.30 points of the gap, leaving 0.10 points for other effects, such as dividend withholding tax, trading costs or cash holdings, after allowing for any securities-lending income.
What to watch for
Tracking difference is not the same as tracking error, and a small tracking difference over one period may hide large offsetting swings. Comparing a fund's price return with an index's total return, or the reverse, creates a misleading gap.