Tracking Error: What It Means for Investors

Imagine aiming an arrow straight at a target, only to find it consistently lands a little off-centre. Close, but not quite perfect. In the world of investing, this slight miss is known as tracking error.

If you invest in index funds or ETFs, you expect your money to mirror the performance of a chosen market index. But in reality, even the best funds don’t perfectly match their benchmarks. That’s where understanding tracking error becomes crucial.

In this guide, we’ll explore what tracking error really means, how it impacts index tracking and fund performance, and how you can use this knowledge to pick better, smarter investments.

What Is Tracking Error?

Simple Definition

Tracking error measures the difference between a fund’s returns and the returns of its benchmark index over time.

• Low tracking error: Fund closely follows the index.
• High tracking error: Fund deviates noticeably from the index.

Quick Analogy: Tracking error is like the difference between following a recipe exactly and adding extra salt or sugar as you go. The dish will be similar, but not identical.

Formula for Tracking Error

Mathematically, it’s often calculated as the standard deviation of the differences between the fund and index returns.

But don’t worry — you don’t need to be a mathematician to understand the practical impact.

Why Tracking Error Matters

1. Accuracy in Index Investing

The whole point of investing in an index fund or ETF is to replicate the market performance, not beat it, not trail it. High tracking error means you’re getting something different from what you signed up for.

2. Impact on Long-Term Returns

Even small deviations, when compounded over the years, can lead to meaningful differences in your portfolio’s value.

3. Trust and Transparency

Low tracking error signals that the fund is doing its job well, efficiently and predictably.

Personal Insight: When I first started investing, I assumed all index funds were identical. Only after seeing slight discrepancies in returns did I learn that tracking error was the silent culprit!

Common Causes of Tracking Error

1. Fund Fees

• Management fees (even low ones) slightly drag returns compared to a pure index.

2. Rebalancing Timing

• Funds may not immediately update holdings when the index changes, leading to small mismatches.

3. Sampling Strategies

• Some funds use sampling rather than buying every stock in the index, especially with large indices.

Example: Rather than owning all 3,000 companies in the Russell 3000, a fund might own a representative sample.

4. Dividend Handling

• Timing and reinvestment of dividends can cause minor variances.

5. Cash Drag

• Funds holding small amounts of cash for liquidity can slightly reduce returns.

6. Currency Fluctuations (for International Funds)

• If your fund tracks a foreign market but is priced in pounds, currency swings can add tracking error.

How to Evaluate Tracking Error

1. Read the Fund Factsheet

• Look for tracking error disclosed as a percentage (e.g., 0.10% or 0.25%).

2. Compare 1-, 3-, and 5-Year Returns

• See how closely the fund’s performance mirrors the index over different periods.

3. Check Independent Reviews

• Morningstar UK, Trustnet, and JustETF often rate funds on tracking accuracy.

Rule of Thumb:

• Excellent: Tracking error under 0.10%
• Acceptable: 0.10% to 0.30%
• Warning Sign: Above 0.30%

Real-World Fund Comparisons

Global Equity Fund Example

Fund Tracking Error Notes Vanguard FTSE Global All Cap Index ~0.08% Highly efficient HSBC FTSE All-World Index Fund ~0.12% Solid, minor deviation.

UK Equity Fund Example

Fund Tracking Error Notes iShares Core FTSE 100 ETF ~0.09% Extremely tight tracking Legal & General UK Index Trust ~0.15% Good, but slightly looser.

Takeaway: A few basis points might seem trivial, but over decades, they compound, just like fees.

Should You Always Pick the Fund With the Lowest Tracking Error?

Not Necessarily!

While lower is generally better, it’s not the only thing to consider:

• Fund size and liquidity: Larger funds often have more stable operations.
• Total cost (including platform fees): Sometimes, a slightly higher tracking error is offset by lower platform costs.
• Your investment goals: Some funds purposely allow small tracking variances to manage costs better.

Golden Rule: Tracking error should be low enough not to meaningfully disrupt your goal of matching the market, but it’s not the sole deciding factor.

Tips to Minimise Tracking Error Impact

1. Stick to Broad, Well-Known Indices

Tracking the S&P 500 or FTSE 100 usually results in tighter tracking than niche or emerging market indices.

2. Choose Reputable Fund Providers

Vanguard, iShares, Fidelity, and Legal & General have strong track records of low tracking error.

3. Avoid Excessively Small Funds

Small or niche funds may struggle to track efficiently, especially during volatile markets.

4. Check Fund Methodology

Does the fund use full replication (best) or sampling (can be less precise)?

5. Review Regularly

Monitoring your investments once a year helps spot any drifting performance.

Staying on Target with Smart Choices

Understanding tracking error is like knowing how well your financial vehicle stays in its lane. When you invest in index funds or ETFs, you want the ride to be as smooth and predictable as possible.

While no fund is perfect, low tracking error ensures your investment sticks closely to the market’s performance without unexpected detours.

Ready to sharpen your investing strategy?

Start today by checking the tracking error of your current holdings — and choose funds that help you hit your financial targets, straight and true!

Did this guide make tracking errors clearer for you? Share it with fellow investors, leave a comment about your experiences with index investing, or subscribe for more plain-English financial insights!