Tracking error definition
Tracking error is the difference between the returns on an investment portfolio and the benchmark that the portfolio was supposed to mimic or replicate. It’s therefore a measure of how well or how badly a portfolio is performing over time.
Tracking error is most commonly calculated as a standard deviation between the returns of the investment portfolio and the returns of the benchmark, although it can also be calculated by subtracting the benchmark’s cumulative returns from those of the investment portfolio.
It’s important for investors to understand tracking error in the context of their own portfolio. Is the portfolio meant to closely mimic the performance of the underlying benchmark as in the case of most passive investing? If so, then a high tracking error signals a problem. An actively managed portfolio, meanwhile, is attempting to create a high positive tracking error.