Tracking error

economic-dictionary

Tracking error is a ratio that measures the profitability differential between an investment fund and its benchmark, for a given period of time.

This ratio is used primarily to compare index funds against their benchmark stock index. Therefore, it measures what is separated with respect to its reference, indicating the good, or bad, management that the manager has carried out in that period.

How is the tracking error calculated?

Its calculation formula is the following:

Tracking error = σ (Rfund - Rmarket)

Where:

  • σ: standard deviation.
  • Rfund: profitability of the fund.
  • Rmarket: performance of the benchmark index.

A high tracking error will indicate that higher risks have been assumed relative to the benchmark to achieve the fund's performance. This is bad, since the idea of ​​index funds is to "copy" their reference, and therefore, if the manager has taken risks greater than the market, it means that the market has done a "mismanagement".

Indexing error is what this ratio measures, quantifying the degree to which the strategy differs from the index or benchmark.

Tracking error characteristics

It is, therefore, characteristic of passively managed funds.

Describes the extent to which the fund manager has deviated from its benchmark. The measure is, however, useful in evaluating performance. The higher the active return (profitability), in relation to the active risk (tracking error), the better.

Due to the variables involved in its calculation, it should be just one more measure in the valuation of a fund.

There are other factors such as the cost (commissions) that this fund has compared to the competition when choosing an index fund. The lower the commissions, the more net profitability the investor will have, being a differentiating factor in this type of fund.

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