Investing term

What is Tracking error?

How far a passive fund's performance drifts from its stated index.

Tracking error measures how far a passive fund's performance drifts from the index it's meant to mirror. A good index fund keeps it minimal — its entire job is to match the benchmark, not to deviate from it — so a small, stable tracking error is a sign the fund is doing its work well.

Persistent tracking error can come from the fund's fee, imperfect replication (holding a sample rather than every security), cash drag, or the costs of trading. Comparing tracking error across similar index funds helps you spot which one most faithfully — and cheaply — delivers the index it promises. A fund that consistently lags its benchmark by more than its fee is leaking return somewhere.

How faithfully a fund tracks its index
100105110startyear endindexfundsmall gap = tracking errorA good index fund hugs its benchmark — the tiny gap it leaves is the tracking error, mostly its fee.

A good index fund hugs its benchmark closely — returning 9.5% against the index's 10%. That small gap is the tracking error, mostly explained by the fund's fee.

For example

An index fund that returns 9.8% when its benchmark returned 10% has a 0.2% tracking error — small, and largely explained by its fee.

Learn it by doing

That's Tracking error in theory — it clicks when you use it. Practise it hands-on in a free, interactive lesson (Stage 6, Index Funds, ETFs & Mutual Funds).

Try the free lesson →

Why it matters to you

Tracking error matters because it tells you how well an index fund actually keeps its promise. Two funds tracking the same index can deliver slightly different returns, and the one with lower tracking error (usually the cheaper, better-run one) gives you more of the index you're paying for. For passive investors, low and stable tracking error — close to the fund's fee — is the quiet mark of quality.

⚠ Ignoring tracking error when funds look identical

Two index funds tracking the same benchmark can seem interchangeable, but differences in fees, replication method, and efficiency show up as tracking error. Picking purely on headline name while ignoring how faithfully each has tracked the index can leave you in the one that quietly lags. Compare tracking error, not just the index and the fee.

Frequently asked questions

What is tracking error?

Tracking error measures how much a passive fund's return deviates from the index it aims to replicate. A low tracking error means the fund closely matches its benchmark; a higher one means it drifts, usually because of fees, imperfect replication, cash drag, or trading costs.

What causes tracking error?

Common causes include the fund's fee (which drags returns below the index), holding a representative sample rather than every security, cash sitting uninvested (cash drag), and the costs of trading to stay aligned with the index. The cheaper and more efficiently run the fund, the lower its tracking error tends to be.

Is a low tracking error good?

For an index fund, yes — its job is to match the benchmark, so low, stable tracking error close to its fee shows it's doing that well. When comparing similar index funds, the one that tracks its index most faithfully (and cheaply) is generally delivering more of what you're paying for.

Read the full guide

Funds & ETFsActive vs Passive ETFs: Is a Stock-Picker Worth the Extra Fee?Active ETFs pay a manager to pick winners; passive (index) ETFs just track the market cheaply. What actually differs — and whether the higher fee is worth it.8 min read

Related terms

Active fundA fund whose manager picks stocks in the hope of beating a benchmark.BenchmarkThe reference index a fund compares itself to — e.g. the S&P 500, MSCI World, or Bloomberg Aggregate.Creation/redemptionThe mechanism that keeps ETF prices close to NAV. Authorized participants swap baskets of underlying stocks for ETF shares (or vice versa).DistributionThe income a fund pays out to its shareholders — dividends from stocks held, plus realized capital gains.
← Back to the full glossary