Definition
Tracking error is the standard deviation of the return gap between a fund or portfolio and its benchmark over time, usually annualized. It measures how consistently a fund follows its benchmark, not whether it is ahead of or behind it.
How it works
Each period, subtract the benchmark's return from the fund's return to get the active return, then take the standard deviation of those gaps. Annualize the result by multiplying the periodic figure by the square root of the number of periods per year, about √12 for monthly or √252 for daily data.
Tracking error measures how consistent the gap is, while tracking difference is the signed gap itself. A fund that lags its benchmark by a steady amount has near-zero tracking error but a negative tracking difference, and a fund whose gaps swing both ways can show a larger tracking error with a difference near zero.
Formula / convention
Tracking error = Standard deviation of (Fund return − Benchmark return); annualized tracking error = periodic tracking error × √(periods per year)
Illustrative example
Illustration with fictional figures: over five months a fund's return minus its benchmark's return was +0.2, −0.2, +0.2, −0.2 and 0.0 percentage points. The average gap is 0.0 and the sample standard deviation is 0.20 points per month, so annualized tracking error is about 0.20 × √12 ≈ 0.69 points. A second fund that trails by exactly 0.04 points every month has zero tracking error even though it lags by about 0.48 points a year.
What to watch for
A low tracking error does not mean strong performance, because a fund can follow its benchmark closely and still lag it after costs. Tracking error is estimated from past data and can change when markets, holdings or the sampling method change.