Tracking Error
Tracking error measures how closely a portfolio follows its benchmark by quantifying variability of active returns.
Definition
Tracking error is the standard deviation of a strategy’s return differences relative to a benchmark. It captures how “active” a strategy is. High tracking error implies meaningful deviation from benchmark holdings or exposures; low tracking error implies a strategy is closer to benchmark behavior. Allocator Context Allocators use tracking error to ensure they are paying active fees for genuine active exposure. A strategy with low tracking error but high fees can be viewed as “closet indexing.” However, low tracking error is not always bad—some mandates explicitly aim for controlled deviations within tight constraints. Decision Authority Tracking error expectations often appear in mandates and manager guidelines. Committees can question fee justification when tracking error is low, especially if benchmark-relative outcomes are modest. Why It Matters for Fundraising Managers should align benchmark selection and tracking error with the mandate. If the strategy is designed to be benchmark-aware, the manager should state this clearly and justify fee structure through process, risk control, or consistent incremental outperformance. Key Takeaways Measures the degree of active deviation from benchmark Useful for fee justification discussions Depends on benchmark appropriateness Often embedded in mandate constraints