Tracking error

Tracking error is defined as the standard deviation of the difference between the fund’s returns and the returns on the index.

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.

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