Tracking error vs tracking difference: Does it matter?

Abstract

Fund fact sheets are intended to provide investors with information necessary to make investment decisions. For passive funds, the inclusion of cumulative returns for the fund and benchmark enable investors to measure the fund’s tracking performance using tracking difference. However, fund managers rely on tracking error to measure tracking performance, which is rarely presented. We evaluate the differences between these two metrics to ascertain whether the use of one or the other measure by investors could impact their investment decision. Results reveal that tracking error and tracking difference capture different elements of tracking performance, with varying rankings across the two measures for a sample of United States (US) funds. The empirical findings are robust to an adjustment for serial correlation, periods of extreme market volatility and varying measurement horizons. Recommendations for industry practice are made in light of these findings.