A tracking error is a difference in performance between a portfolio and the benchmark being used to make decisions about investments in that portfolio. Tracking errors always occur on some level because it is impossible to perfectly replicate the performance of a benchmark. The size of the error can provide important indicators about how well the portfolio is being managed, as well as shedding light on market volatility and other issues that may be having an impact on portfolio performance. Typically, the tracking error is expressed in the form of the standard deviation between the portfolio's returns and the benchmark's returns.
The expected tracking error varies, depending on the type of portfolio. An investment like an index fund would be expected to have a low error rate because it is pegged directly to a stock index, and thus the difference in performance between the fund and the index should be relatively low. Tracking errors with stock index funds are usually caused by the costs of managing the fund, as these will eat slightly into profits.
Errors can be higher with other types of financial products like managed funds when compared against various benchmarks. When analyzing fund performance, economists are careful to use the same benchmark so the analysis is consistent and the evaluation of performance can be compared over previous reports. This is especially important in situations where tracking errors may fluctuate dramatically, as switching benchmarks could obscure or confuse an analysis.
Investors can examine the tracking errors for various investment products and these errors are often considered when making decisions about where to invest. Financial publications typically publish reviews of publicly available financial products like stock index funds to help investors make informed decisions about how they want to distribute their investments. These reviews will include a tracking error disclosure and discussion. Financial advisors can also provide people with information about the past and present performance of financial products they are interested in.
When evaluating a tracking error, it is important to consider extenuating circumstances. A fund may be very well managed by a competent and talented staff, but in the event of major economic upheaval, it can be impossible to control returns. Performance of a financial product may fluctuate wildly until the economy settles down and the people managing the product have an opportunity to regroup. Conversely, sometimes funds perform well during downturns because their management is especially quick on the draw, but on occasion, these good performances are attributable more to luck than skill.