Tracking Error
Tracking error is the difference between how an index fund or ETF performs and how the index it’s trying to follow performs.
Why it matters
- Index funds and ETFs are designed to match, not beat, their benchmark index.
- Lower tracking error means the fund is doing a better job of staying close to the index.
- High or inconsistent tracking error can make your portfolio behave differently than you expect.
Why tracking error happens
- Fees: MER and trading costs reduce returns vs. the index.
- Sampling: Some funds hold only a subset of index holdings.
- Cash drag: Funds may hold some cash, especially when receiving inflows or outflows.
- Rebalancing & timing: Differences in when the fund adjusts its holdings compared with the index.
Simple example
If an index returns 8% in a year but the ETF that tracks it returns 7.6%, the 0.4 percentage-point gap is largely tracking error (including the MER and other frictions).