Tracking error

Key Takeaways

  • Tracking error is the relative risk of a portfolio compared to its benchmark
  • It is used in reference of a mutual fund, hedge fund or an exchange traded fund
  • Tracking error can also be a comment on the performance of a portfolio manager

What is a Tracking error?

Tracking error is the relative risk of a portfolio compared to its benchmark. It is usually used to gauge the performance of an investment. Tracking error is often used in reference to a mutual fund, hedge fund or an exchange traded fund. Tracking error can also be a comment on the performance of a portfolio manager.

Tracking error formula

Tracking error can be calculated as the standard deviation of the difference between a portfolio’s returns and its benchmark’s returns: –

Tracking error
Source: Tavaga

Where TE refers to the tracking error and s(Rp – RB) indicates that we take the sample standard deviation (indicated by s) of the time series of difference between the portfolio return, Rp, and the benchmark return, RB. We should be careful that active return and tracking error are stated on the same time basis.

Factors affecting Tracking Error

Tracking error can be caused by two reasons. First, by the trading cost and second, by improperly replicating the index. For an ETF, tracking error is the deviation in performance of the fund and its index. It occurs primarily because of the ETF’s total expense ratio (a kind of trading cost).

If the expense ratio of a fund is high, it can have an extremely negative effect on the performance of the fund. However, the impact of this negative effect can be mitigated by fund managers if they do an excellent job of managing dividends and interest payments, portfolio rebalancing, or securities lending.

Illiquid securities can also lead to tracking error as they often have a wider bid-ask spread. Volatility is another factor that can impact the tracking error for an index.

Tracking error from erroneous replicating an index creeps in when the index gets rebalanced and repopulated with a new makeup of securities, but the fund’s basket of securities is yet to be changed to reflect that.

Factors affecting an ETF Tracking Error

Factors apart from the expense ratio, which is already discussed above, that can seep in and cause tracking error in ETFs are:

Discounts and Premiums to Net Asset Value: Discounts and Premiums to Net Asset Value might happen when an investor bids the ETF’s market price below or above the NAV.

Optimisation: When thinly traded stocks are present in the benchmark index, it is not possible for an ETF provider to purchase them without excessively pushing their price up. Therefore, it makes use of a sample having the higher liquid stocks to proxy the benchmark index.

Cash Drag: Unlike indexes, ETFs do have cash holdings. The time lag between receiving the cash and reinvesting it can possibly cause variance.

Index Changes: ETFs need to follow the suit when the indexes have changes or are updated. While updating, ETFs incur transaction costs which might not always be the same as that of index.

Capital Gains Distribution: ETFs are known to be more tax efficient in comparison to mutual funds. But ETFs also tend to distribute the capital gains which are taxable to the unitholders. On the after-tax basis, these distributions create differences in performance than the index.

Currency Hedging: International exchange traded funds with currency hedging might not follow a particular benchmark index because of the currency hedging cost. Interest rate differentials and market volatility can affect hedging costs.