Tracking Error
Tracking error is the volatility of the difference between a portfolio’s returns and its benchmark’s returns.
Allocator relevance: Helps quantify active risk—useful for understanding how “different” a manager is versus the benchmark and sizing accordingly.
Expanded Definition
Tracking error measures how much a strategy deviates from its benchmark. A low tracking error suggests benchmark-like behavior (closet indexing), while high tracking error indicates meaningful active bets. For allocators, it’s a tool to align portfolio role: diversifiers vs return engines vs benchmark-aware mandates.
Tracking error is most applicable in liquid strategies where benchmarks and frequent pricing are meaningful; it is less reliable in private markets with lagged marks.
How It Works in Practice
Teams compute tracking error over consistent windows, compare against peer ranges, and evaluate whether active risk is intentional and compensated (alpha). They pair it with information ratio and drawdown metrics.
Decision Authority and Governance
Governance defines acceptable tracking error ranges by mandate. Out-of-band tracking error can signal style drift or hidden leverage.
Common Misconceptions
- High tracking error automatically means higher skill.
- Low tracking error means “safe.”
- Tracking error works the same for private markets.
Key Takeaways
- Tracking error is an active risk lens.
- Best used for liquid benchmarked strategies.
- Pair with alpha attribution and drawdown analysis.