Tracking Error
In short
Standard deviation of active returns vs benchmark — how much you deviate
If your portfolio closely mirrors the index, tracking error is low. If you make big independent bets, it's high. Index funds have near-zero tracking error. Active funds that differ from the benchmark have high tracking error.
Tracking error is the annualized standard deviation of the difference in returns between a portfolio and its benchmark. Low tracking error (<2%) indicates passive or closet-index strategies. Active strategies typically have tracking error of 5-15%.
Formula
TE = σ(Rp - Rb) annualizedThresholds
- <2
- Near index — low active risk
- 2-5
- Moderate active positioning
- 5-15
- Highly active — significant bets
- >15
- Very high — concentrated strategy
Related concepts
- Information Ratio — If a manager beats the market by 2% per year on average, but the outperformance swings wildly (+10%, -6%, +2%...), the information ratio is low. Higher IR means consistent, reliable outperformance.
- R-Squared (R²) — R-squared tells you how much your portfolio moves in sync with the overall market. An R² of 0.95 means 95% of your portfolio's ups and downs are explained by the market. A low R² means your returns come from other factors — which can be good (alpha) or risky (concentrated bets).
- Alpha — Alpha is the extra return a fund earns above what you'd expect given its risk. If the market returns 10% and your fund returns 13% with the same risk, alpha is 3%. Positive alpha = the manager adds value.
- Beta — Beta of 1.0 means the stock moves in line with the market. Beta of 1.5 means if the market rises 10%, this stock typically rises 15% — more volatile. Beta of 0.5 means less volatile than the market.