Financial Dictionary - Tracking Error
This measures the deviation of a fund from the benchmark index as result of the securities selected. Tracking error is also used to measure the probability that a portfolio will diverge from the benchmark.
It is commonly used to analyse the regularity of a fund's returns and is a clear indicator of good management by the management team.
How is tracking error interpreted?
The higher it is, the more active the fund management will be and the lower the chances of mirroring the benchmark. The lower the tracking error, the higher the probability that its behaviour is similar to that of the benchmark.
If it is 0, the fund is behaving like its benchmark index. These results correspond to passive management funds and would be the case, for example, of funds or ETFs on the Ibex 35 whose results are practically the same as the results of the Ibex 35.
Between 2% and 4% is considered to be low, implying management with a higher, but controlled, risk.
Above 6% to 7% is considered to be high and corresponds to the results of actively managed funds. When a tracking error is high, it indicates that greater risks have been assumed to achieve the fund's profitability.
It's also important to bear in mind that the tracking error is only a risk measure. On its own, it doesn't reflect the quality of the management and it should therefore be supplemented with the use of other profitability indicators. For example, another important factor to note is the cost of a fund compared to the competition, because the cost or fee will determine the net profitability from the investment.