Understanding and Optimizing Tracking Error for Better Investment Management

Explore the concept of tracking error, how it impacts investment performance, and techniques to minimize it for maximizing portfolio returns.

Understanding and Optimizing Tracking Error for Better Investment Management

What is Tracking Error?

Tracking error is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark. This often occurs in the context of a portfolio like a hedge fund, mutual fund, or exchange-traded fund (ETF), creating an unexpected profit or loss when the investment doesn’t perform as intended. Tracking error is reported as a standard deviation percentage difference, measuring the gap between the return an investor receives and the benchmark they were attempting to mirror.

Key Takeaways

  • Tracking error is the difference in performance between a position (usually an entire portfolio) and its corresponding benchmark.
  • It serves as an indicator of how actively a fund is managed and its corresponding risk level.
  • Evaluating a past tracking error of a portfolio manager may provide insight into the level of benchmark risk control the manager may demonstrate in the future.

Understanding Tracking Error

Since portfolio risk is often measured against a benchmark, tracking error is a crucial metric to gauge how well an investment is performing. Tracking error illustrates an investment’s consistency versus a benchmark over a given period. Even perfectly indexed portfolios exhibit slight differences from their benchmarks. Here’s how tracking error is calculated:

Tracking Error = Standard Deviation of (P - B)

  • Where P is portfolio return and B is benchmark return.

For investors, tracking error helps assess portfolio managers’ effectiveness. If a manager has low average returns combined with a large tracking error, it signifies issues that might warrant finding a replacement. Tracking error is also used by quantitative managers to forecast performance and implement risk models.

Factors Influencing Tracking Error

Expense Ratios and NAV Divergence

The net asset value (NAV) of an index fund tends to be lower than its benchmark due to the presence of fund fees. However, exceptional fund management involving rebalancing, managing dividends, or securities lending can counter these fees and enhance performance.

Holdings and Weighting Differences

Funds often hold a representative sample of the benchmark’s securities. Variances in holdings and their weightings can cause tracking errors. Illiquid or thinly-traded securities can worsen this issue, as they lead to significant pricing differences during trading.


The volatility level of an index affects its tracking error. Sector, international, and dividend ETFs typically have higher absolute tracking errors, while broad-based equity and bond ETFs exhibit lower ones.

Premiums and Discounts to NAV

Premiums or discounts occur when ETF prices deviate from the NAV of their basket of securities. Authorized participants usually arbitrage these discrepancies away. Premiums and discounts as high as 5% are known, especially in thinly traded ETFs.

Optimization and Sampling

ETF providers may sample the more liquid stocks of a benchmark index to avoid pushing up prices of less liquid stocks. This process, known as portfolio optimization, minimizes large price shifts and errors.

Diversification Constraints

ETFs comply with legal diversification constraints. For example, 75% of their assets must be in diverse securities and no more than 5% in any single security. This constraint can be challenging when tracking indexes with dominant companies.

Cash Drag

ETFs hold cash, unlike benchmarks without cash resources, primarily due to dividend payments, overnight balances, and trading activities. The lag from accumulating and reinvesting cash can lead to performance declines called ‘cash drag.’ High-yield dividend funds are more susceptible to this phenomenon.

Index Changes

Updates in the benchmarks compel ETFs to follow with their portfolio changes, incurring costs and sometimes resulting in discrepancies due to timing and price variations.

Capital-Gains Distributions

Though more tax-efficient than mutual funds, ETFs still distribute taxable capital gains, impacting their tracking error from an after-tax performance perspective. Higher turnover in fund components leads to higher gains distributions.

Securities Lending

To reduce tracking error, some ETF companies engage in securities lending, collecting fees from hedging funds involved in short selling, which can be used to moderate tracking errors.

Currency Hedging

ETFs using currency hedging techniques may not perfectly align with benchmark indexes, with factors like market volatility and differential interest rates affecting performance.

Futures Roll and Maintaining Leverage

Commodity ETFs execute futures roll by buying and selling near-expiry contracts monthly, which could incur losses if in contango. Leveraged ETFs maintain consistency with their benchmarks through daily derivatives rebalancing.

Illustrative Example of Tracking Error

Consider a large-cap mutual fund benchmarked to the S&P 500 index over five years with the following returns:

  • Mutual Fund: 11%, 3%, 12%, 14%, and 8%.
  • S&P 500 index: 12%, 5%, 13%, 9%, and 7%.

Calculating their differences provides: ‑1%, ‑2%, ‑1%, 5%, and 1%. The standard deviation of these differences, calculated as tracking error, is 2.50%.

Related Terms: standard deviation, net asset value, expense ratio, risk management, portfolio optimization.


  1. U.S. Government Publishing Office. “Investment Act of 1940”, Page 24.

Get ready to put your knowledge to the test with this intriguing quiz!

--- primaryColor: 'rgb(121, 82, 179)' secondaryColor: '#DDDDDD' textColor: black shuffle_questions: true --- ## What is tracking error? - [ ] The deviation between a security's price and its moving average - [x] The divergence between the price behavior of a portfolio and the price behavior of a benchmark - [ ] The error in reading technical indicators - [ ] The difference between actual returns and expected returns ## Tracking error is most commonly associated with which type of funds? - [x] Index funds - [ ] Hedge funds - [ ] Mutual funds - [ ] Private equity funds ## What is a high tracking error indicative of? - [ ] Perfect alignment with the benchmark - [x] Poor alignment with the benchmark - [ ] Lower market volatility - [ ] Higher liquidity in the portfolio ## Which of the following is NOT commonly used in calculating tracking error? - [ ] Standard deviation of excess returns - [ ] Total risk of a portfolio - [x] Beta coefficient - [ ] Variance of portfolio vis-a-vis the benchmark ## Tracking error is an important metric for which kind of investors? - [ ] Speculative traders - [x] Passive investors - [ ] Real estate investors - [ ] Venture capitalists ## What does a tracking error of zero signify? - [x] Exact replication of benchmark returns - [ ] High degree of portfolio risk - [ ] Maximum divergence from the benchmark - [ ] Indicative of bad performance ## How can a fund manager reduce tracking error? - [ ] By making radically different investments from the benchmark - [ ] By increasing the number of speculative trades - [x] By mimicking the benchmark more closely - [ ] By ignoring market trends ## What does a positive tracking error tell you? - [ ] The portfolio underperformed the benchmark - [x] The portfolio either outperformed or underperformed the benchmark - [ ] The portfolio perfectly matched the benchmark returns - [ ] The portfolio has no risk ## What could be a primary cause of tracking error in an index fund? - [ ] Immunization strategies - [ ] Arbitrage opportunities - [x] Fees and expenses charged by the fund - [ ] Regulatory compliance ## If a portfolio manager is aiming to minimize tracking error, their investment approach is likely: - [ ] Highly speculative - [ ] Aggressive - [x] Passive and closely aligned with the benchmark - [ ] Focused on emerging markets