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Tracking error

Tracking Error

Tracking error is a measure of how closely a portfolio or fund follows the performance of a benchmark index. It is calculated as the standard deviation of the differences between the portfolio’s returns and the benchmark’s returns. A low tracking error indicates that the portfolio closely follows the index, while a high tracking error suggests more divergence. Tracking error is commonly used to evaluate the performance of index funds and other passive investments.

Example

An ETF that aims to replicate the S&P 500 index has a tracking error of 0.5%, meaning its returns have deviated from the index by an average of 0.5% over time.

Key points

• Measures the difference between a portfolio’s performance and its benchmark index.

• Expressed as the standard deviation of the return differences.

• Used to evaluate the effectiveness of passive investment strategies.

Quick Answers to Curious Questions

Why is tracking error important for index funds?

It shows how closely an index fund tracks its benchmark, helping investors understand the fund’s performance relative to the index.

What factors can cause tracking error in a portfolio?

Factors include management fees, transaction costs, and differences in the timing of trades compared to the benchmark.

How can investors use tracking error to evaluate fund performance?

Investors use tracking error to assess how well a fund replicates its benchmark, with lower tracking errors indicating better index replication.

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