Tracking error is a measure of financial performance out of many, to scale the performance of an investment versus its estimated benchmark set for a given time period.
It helps measure the difference between the return fluctuation of an investment portfolio like a mutual funds scheme and the benchmark return fluctuation.
In other words, tracking error is also known as the difference between the price behavior of a portfolio and a benchmark.
What Does Tracking Error State?
The one financial instrument like fund schemes with less tracking error states the scheme is giving returns as per the benchmark where schemes with much tracking error mean the portfolio is not working as per the set standards.
The financial institutions’ managers aim to minimize the tracking error by minimizing the differential returns as low as possible.
Can Tracking Error Hit Zero?
Tracking error can never be zero in index funds because of the expense ratio, funds flow, and portfolio realignment due to the dynamic composition of an index fund.
Also, a number close to zero indicates a bound portfolio return set against benchmark returns.