Tracking Error – Importance, How To Calculate and Limitations

Investors use various tools to measure risk and return from investment vehicles. Tracking error is the difference between how a portfolio performs compared to a benchmark. It’s expressed as a percentage, representing the standard deviation of this difference. Investors use tracking error to assess how well an investment matches the benchmark’s return, serving as a measure of consistency over time in relation to the benchmark.

To know more about tracking error and how it is calculated, read further. 

What is a tracking error?

Tracking error is a measure of the difference between an investment portfolio’s returns and the benchmark index it was meant to beat. Tracking error is also described as a standard deviation percentage gap that reports the difference between the returns an investor gains and the benchmark they were planning to surpass. 

In a perfect world, it would be preferable if the tracking error or active risk was low or moderate. If this number is high, regardless of performance, it indicates that the portfolio manager has taken a higher-than-appropriate risk.

Tracking error is mainly associated with passive investment vehicles. It helps to gauge the performance of mutual funds, hedge funds, or Exchange-traded Funds (ETFs).

• Tracking error can be defined as the difference between an investment portfolio’s returns and the index it mimics.  
• Tracking error is a handy measurement of how well a fund is being managed, the potential risks for investors, and the performance of portfolio managers.
• The higher the tracking error, the more the portfolio manager diverges from the benchmark. The lower the tracking error, the closer the portfolio manager follows the benchmark.

Factors that affect tracking error

There are factors that determine a portfolio’s tracking error; some of which include:

• Number of stocks in the portfolio
• Differences in market capitalisation, investment style, timing, and other characteristics of the portfolio 
• Change of index constituents
• Corporate actions
• Market volatility
• The management fees, brokerage costs, custodial fees, and other expenses affecting the investment portfolio that don’t affect the benchmark
• The portfolio’s beta

Importance of tracking error 

Tracking error is crucial for assessing a portfolio’s performance and the ability of a fund manager to garner excessive returns and outdo the benchmark. Additionally, this is why tracking error is important:

• Tracking error helps measure and compare a portfolio’s performance with the respective index or benchmark.
• It helps to recognise the consistency of higher returns.
• Portfolio managers leverage tracking errors to determine how close an investment portfolio is to its benchmark.
• With the help of tracking errors, investors get a chance to ascertain how reliable a fund manager’s investment strategy is.

Ultimately, tracking error is a strong indicator of a portfolio manager’s proficiency and a reflection of how well the portfolio is managed. 

For instance, actively managed portfolios carry high risk. On the other hand, passively managed portfolios replicate index funds, and thus a large tracking error is considered unpleasant for such investors. Hence, tracking errors can be leveraged as a tool to set acceptable performance benchmarks for fund managers. 

You can also use Tickertape’s Mutual Fund Screener to analyse the performance of a fund. There are more than 50+ filters that help you to determine the best fund.

How to calculate tracking error?

There are various ways to measure tracking errors. The first method involves subtracting the benchmark’s cumulate returns from the portfolio’s returns. The tracking error formula for this method is:

Tracking error = Return(p) – Return(i)

Where;

p = portfolio 

i = index or benchmark

Let’s understand the concept of tracking error with the help of an example. Let’s say that ABC Fund is supposed to track Sensex. The previous year, the Sensex returned 10%, while the ABC Fund returned 9.7%. The difference between the two: 9.7% – 10% = -0.3% is the tracking error. 

The second method, on the other hand, is way more common and offers a more accurate calculation, which includes calculating the standard deviation of the difference in the portfolio, as well as benchmarks returns, over time. Here’s how to calculate tracking error using the second method:

Here, TE = Tracking error

Rp = Return of portfolio

Rb = Return of benchmark

N = Number of return periods

In this case, let’s assume the following returns for the ABC Fund and Sensex:

• Sensex (10%, 5%, 7%, 2%, 8%)
• ABC Fund (9.7%, 4.6%, 7.2%, 2.2%, 7.8%)

But how do we locate the tracking error on the basis of this information?

First, we calculate the simple tracking error of every period by subtracting Sensex’s performance from ABC Fund’s performance. These are the values we will attain (-0.3%, -0.4%, 0.2%, 0.2%, -0.2%). We then square each value (0.09%, 0.16%, 0.04%, 0.04%, 0.04%). Then, we do a total of these five values, which rounds up to 0.37%. The next step is to divide the sum by N – 1 or (5-1) = 0.0925%. 

Lastly, we do the square root of 0.0925% to identify the tracking error, which comes to 0.304% in this case.

You can also use Tickertape to find the tracking error of a fund. Launch the Mutual Fund Screener and search for ‘Tracking Error’ in ‘Add Filter’.

What are some of the limitations of tracking error?

Typically, investors may accept high tracking errors if a fund’s performance is excellent. However, the same may not be true if returns are low. In that sense, viewing tracking errors in isolation can misguide an investor because, at the end of the day, several factors need to be considered when viewing a fund’s performance.

Distinguishing between funds based on tracking error alone may not be wise.

Conclusion

Although rarely given importance, track errors can significantly impact an investor’s returns. Conceptually, if an index fund holds a high tracking error, it defeats the purpose of index investing. So, when choosing an Index fund, go for a fund with a low tracking error. As an investor, you must investigate tracking errors to determine your true returns. 

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