Tracking Error

In finance, tracking error is a measure of how closely a portfolio follows the index to which it is benchmarked. The best measure is the root-mean-square of the difference between the portfolio and index returns.

Many portfolios are managed to a benchmark, typically an index. Some portfolios are expected to replicate, before trading and other costs, the returns of an index exactly (e.g., an index fund), while others are expected to 'actively manage' the portfolio by deviating slightly from the index in order to generate active returns. Tracking error (also called active risk) is a measure of the deviation from the benchmark; the aforementioned index fund would have a tracking error close to zero, while an actively managed portfolio would normally have a higher tracking error. Dividing portfolio active return by portfolio tracking error gives the information ratio, which is a risk adjusted performance measure.

Read more about Tracking Error:  Definition, Examples

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Index Fund - Disadvantages - Possible Tracking Error From Index
... returns, both under- and over-performance compared to the market is considered a "tracking error" ... For example, an inefficient index fund may generate a positive tracking error in a falling market by holding too much cash, which holds its value compared to the ... According to The Vanguard Group, a well run S P 500 index fund should have a tracking error of 5 basis points or less, but a Morningstar survey found an average of 38 basis points ...
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... ETNs give investors a broad-based index without any tracking error to the index, doing away with the discrepancies that exist between the returns of many ETFs and their underlying indexes ... One reason of the tracking error observed in ETFs might be attributed to the diversification issues that stem from the inability of a fund to replicate an index due to an upper limit on the maximum asset ... for ETN, this constraint does not exist, because though ETN is also tracking the index, the return is not based on the underlying securities ...

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