Tracking error

In an ideal world, a tracker fund or exchange-traded fund (ETF) would perfectly match the index it is supposed to follow – so a FTSE 100 tracker will deliver exactly the same return as the FTSE 100. In reality, it will almost always lag or beat the index by some amount.

For tracker funds, both underperforming and outperforming the index are technically equally bad, since the measure of a good tracker is how closely it manages to track its underlying index. This can be influenced by a number of things, ranging from the methodology used to replicate the underlying index (does it hold all of the stocks in the index, or just a representative sample?) to trading costs to how much money the fund is able to make from lending out shares to short-sellers.

The quality of a tracker is measured by using two different statistics: tracking difference and tracking error. Tracking difference is the easiest of the two to understand. It refers to the difference between the return on the index and the return of the fund over a set period of time. So if an index returns 15% and the fund returns 13.7%, the tracking difference is -1.3%.

Tracking error is defined as the standard deviation of the difference between the fund’s returns and the returns on the index, which essentially means it measures how volatile the fund’s tracking difference is. For example, a fund that had annual tracking differences of -1.3%, 0.5%, -1%, 0.15% and -0.5% in successive years would have a tracking error of 0.76%.

If you plan to invest in a tracker, you will want to see both consistently low tracking difference and tracking error. All else being equal, given the choice between two tracker funds, you would want to invest in the one with the lowest tracking error.