The tracking error can be an important factor in portfolio management, although investors often overlook this measure for indexed exchange-trade funds (ETF) or mutual funds. All index funds do not perform exactly the same, nor do they all perfectly match up with the index or benchmark they are designed to track. The tracking error is simply the amount by which a fund's return, as indicated by its net asset value (NAV), varies from the actual index return.

The term "tracking error" can be misleading. It is not necessarily a negative, since the deviation from the index can be positive for investors if their chosen fund outperforms the index. However, one of the main reasons for investors to watch for a tracking error is the fact that historical analysis shows that, on average, many more index funds underperform, rather than outperform, the underlying index.

Analysts recommend considering the tracking error as one factor when making the decision of choosing one index fund over another.

How to Calculate the Tracking Error

You may calculate the tracking error by doing a standard deviation percentage calculation. However, a simpler method is to just subtract the index or benchmark return from the portfolio return.

For example, if an index or benchmark gains two percent over the course of a year, but an index mutual fund that tracks the index gains three percent over the same time period, then the tracking error for that mutual fund is one percent.

Variations between index funds can be significant, with one fund outperforming an index by as much as five percent while another fund aimed at tracking the same index may underperform it by almost five percent. Deviations in returns between funds and an underlying index tend to be greater for sector funds as compared to general market funds, such as those that track the S&P 500 Index.

Factors That Can Affect a Tracking Error

The NAV of an index fund is naturally inclined toward being lower than its benchmark because funds have fees, whereas an index does not. A high expense ratio for a fund can have a significantly negative impact on the fund's performance. However, it is possible for fund managers to overcome the negative impact of fund fees and outperform the underlying index by doing an above-average job of portfolio rebalancing, managing dividends or interest payments, or securities lending. The tracking error can be viewed as an indicator of how actively a fund is managed and its corresponding risk level.

Beyond fund fees, a number of other factors can affect a fund's tracking error. One important factor is the extent to which a fund's holdings match the holdings of the underlying index or benchmark. Many funds are made up of just the fund manager's idea of a representative sample of the securities that make up the actual index. Commonly, there are also differences in weighting between a fund's assets and the assets of the index.

Illiquid or thinly traded securities can also increase the chance of a tracking error, since this often leads to prices differing significantly from market price when the fund buys or sells such securities, due to larger bid-ask spreads. Finally, the level of volatility for an index can also affect the tracking error.

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