Tracking Difference and Tracking Error

Tracking difference and tracking error are both used to assess how closely a fund follows its benchmark. Although the terms sound similar, they measure different things.

Tracking Difference

Tracking difference measures the actual difference in total return between the fund and its benchmark over a specific period. It reveals exactly how much a fund outperformed or underperformed by the end of that period.

• Formula: Rfund − Rbenchmark

• Interpretation: If an index returns 10% and the fund returns 9.8%, the tracking difference is -0.2%. Passive funds generally have a negative tracking difference due to fees (OCFs), transaction costs, and cash drag.

Tracking Error

Tracking error measures the consistency or variability of the performance gap over time. It is the annualised standard deviation of the difference in returns.

• Formula: Standard deviation of (Rfund − Rbenchmark)

• Interpretation: A low tracking error means the fund hugged the index closely every period, regardless of whether it was consistently outperforming or underperforming. A high tracking error means the fund’s excess returns fluctuate wildly compared to the index.

To clarify these concepts, think of an index as the lead car of two cars on a road trip. The tracking difference is the distance between the two cars at the final destination, whilst the tracking error is how erratically the second car drove during the trip.

In other words, tracking difference tells you where the fund finished relative to the benchmark. Tracking error tells you how smooth or erratic the journey was.