What is a Tracking Error?

Sometimes referred to as an active risk, a tracking error is a situation where there is a difference between the price behavior of a benchmark associated with an asset in investment portfolio, and the behavior of a position associated with that same asset. This type of divergence normally occurs when a hedge fund or mutual fund does not perform in the manner that was previously anticipated, resulting in either a return that is higher than projected, or a loss that was not expected to occur. There are several ways to measure a tracking error, depending on the nature of the benchmark.

One of the more common ways to measure a tracking error involves assessing the difference between the portfolio and benchmark returns, where the benchmark is associated with an index. This process involves identifying the root-mean-square of that difference. Essentially, this process involves squaring each number associated with the returns, then determining the average of those squares, and finally identifying the square root of the average. This process provides a more accurate assessment than simply obtaining an average of the numbers involved, and makes it easier to determine the exact degree of divergence that is present between the actual return and the standard or benchmark that was anticipated.

In calculating a tracking error, the data used may be historical in nature. When that is the case, the result is known as an ex-post error. Should the calculation be based on estimates for future returns, the resulting figure is known as an ex-ante error. Regardless of the origin of the data, the outcome can be affected by such factors as the management fees charged by brokers and dealers, the trading costs associated with the investment, and the differences in how the benchmark for the investment is determined.

It is not unusual for some small amount of tracking error to be present with most investments involving mutual funds or hedges. The error may represent a loss, in that the asset did not perform as well as anticipated. At the same time, the error can also represent an unexpected gain, assuming the actual return is greater than the benchmark identified by the investor. Taking the time to calculate the tracking error can be instructive, since the process can provide the investor with data that may be been overlooked using other methods, and thus increase the chances that the investment will perform at a level that is within the expectations of the investor.