Tracking error

In <a href="/facts/Finance/fLh1GgN8">finance</a>, tracking error or active risk is a measure of the risk in an <a href="/facts/Investment_portfolio/hTnbPr1C">investment portfolio</a> that is due to <a href="/facts/Active_management/rE2RhG20">active management</a> decisions made by the <a href="/facts/Portfolio_manager/qbuNEmn7">portfolio manager</a>; it indicates how closely a portfolio follows the index to which it is benchmarked. The best measure is the <a href="/facts/Standard_deviation/qSug9BRl">standard deviation</a> of the difference between the portfolio and index returns.
Many portfolios are managed to a benchmark, typically an index. Some portfolios, notably <a href="/facts/Index_fund/ULAIr8j0">index funds</a>, are expected to replicate, before trading and other costs, the returns of an index exactly, while others '<a href="/facts/Active_management/rE2RhG20">actively manage</a>' the portfolio by deviating from the index in order to generate <a href="/facts/Active_return/rxxEkANr">active returns</a>. Tracking error measures the deviation from the benchmark: an index fund has a near-zero tracking error, while an actively managed portfolio would normally have a higher tracking error. Thus the tracking error does not include any risk (return) that is merely a function of the market's movement. In addition to <a href="/facts/Financial_risk/UdGAclEI">risk</a> (return) from specific stock selection or industry and <a href="/facts/Factor_analysis/LT6B9I7D">factor</a> "betas", it can also include risk (return) from <a href="/facts/Market_timing/V1RkM9oy">market timing</a> decisions.
Dividing portfolio active return by portfolio tracking error gives the <a href="/facts/Information_ratio/6NWbTPeP">information ratio</a>, which is a risk adjusted performance measure.

Tracking error open-in-new

Tracking error