Tracking error

Tracking error measures how far your portfolio wanders from the benchmark. Not whether it did better or worse, but how much the gap between the two moves around.

It is volatility applied to the difference rather than to the portfolio itself.

How it is calculated

Gylder computes the active return for each day, which is your return minus the benchmark's return on that day. Tracking error is the standard deviation of those daily differences, annualised:

active return   = portfolio daily return − benchmark daily return
tracking error  = standard deviation of active returns × √252

A portfolio that mirrors the benchmark exactly has a tracking error of zero. An index fund's would be a fraction of a percent. A concentrated portfolio of individual holdings will be many percent.

How to read it

Tracking error is directionless. It is equally large whether you diverged by beating the benchmark or by trailing it, so a high figure tells you that you are doing something different, not that it is working.

That makes it most useful paired with a measure of direction:

• With the information ratio, which divides your average active return by exactly this number. Tracking error is the denominator there, so the two are best read together.
• With alpha, for whether the divergence paid.

A near-zero tracking error against a benchmark you did not intend to track is worth noticing, because it means your portfolio is doing roughly what the index does. Whether that is what you want is your call, and Gylder does not have an opinion on it.

Caveats

The figure is only as meaningful as the benchmark. Measured against an index that has little to do with what you hold, tracking error mostly reports that the two are different things, which you already knew.

It also inherits the sampling limitation of every measure here. Deep in history, your value series is stored weekly rather than daily, so a tracking error computed over a long window is a smoothed approximation.