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What is a Tracking Error?

Tracking error is a measure of financial performance out of many, to scale the performance of an investment versus its estimated benchmark set for a given time period.

It helps in measuring the difference between the return fluctuation of an investment portfolio like mutual funds scheme and the benchmark return fluctuation.

The one financial instrument like fund schemes with less tracking error states the scheme is giving returns as per the benchmark where schemes with much tracking error mean the portfolio is not working as per the set standards.

The managers at financial institutions aim at minimizing the tracking error by minimizing the differential returns as low as possible.

Tracking error can never be zero in index funds because of the expense ratio. Funds flow and realigning of funds portfolio whenever there is a change in the composition of an index.

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