An investment can get off track, but a fund’s “tracking error” measures how it stacks up to the broader market.
Tracking error measures the difference between “the price behavior of a position or a portfolio and the price behavior of a benchmark,” Investopedia. A higher tracking error indicates that an or “did not work as effectively as intended, creating an unexpected profit or loss.”
“Low errors indicate that the performance of the portfolio is close to the performance of the benchmark,” the Corporate Finance Institute. “Low errors are common with index funds and ETFs that replicate the composition of major stock market indices.”
“High errors reveal that the portfolio’s performance is significantly different from the performance of the benchmark. The high errors can indicate that the portfolio substantially beat the benchmark, or signal that the portfolio significantly underperforms the benchmark,” according to the CFI.
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Tracking error can be influenced by “how closely a fund’s holdings mirror those of its benchmark index,” the timing of trades and trading volumes on a particular stock exchange, and market , ETFstream.
The CFI commented: “Tracking error is one of the most important measures used to assess the performance of a portfolio, as well as the ability of a portfolio manager to generate excessive returns and beat the market or the benchmark.”