Tracking error.

In plain English

Tracking error is the standard deviation of the gap between a fund's return and its index return over a series of periods, reported as an annual percentage. For an index fund the goal is a number near zero, and the usual causes of drift are fees, cash held for redemptions, sampling instead of full replication, and the timing of index changes. For an active fund a larger tracking error is deliberate, since the manager has to differ from the index to have any chance of beating it. The measure describes the size of the deviation, not its direction, so a fund that consistently beats its index still shows tracking error. It is different from tracking difference, which is the plain average gap.

01Why it matters

Tracking error tells an index fund holder whether they are getting the market they signed up for, and it tells an active fund holder how different a bet they are actually taking.

02The math, step by step

A fund trails its index by 0.10, then leads by 0.05, then trails by 0.15 percent across three quarters. The average difference is a shortfall of about 0.07 percent, while the volatility of those three gaps is what tracking error captures. Two funds with the same average shortfall can differ a lot in consistency.

Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.

03What this is NOT

04Receipts

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