Tracking Error (Index Funds & ETFs)

Tracking error measures how far an index fund or ETF's returns drift from its benchmark index, caused by costs, cash holdings, and rebalancing lag.

What It Means

Tracking error measures how closely an index fund or ETF's actual returns follow its benchmark index. A tracking error of zero would mean the fund's returns matched the index exactly, day for day; in practice every index fund has some tracking error, and a lower number means it's doing its one job, mirroring the index, more faithfully.

How It Works

Tracking error comes from a handful of real, unavoidable sources: the fund's expense ratio, which the index itself doesn't pay; a small cash buffer the fund keeps for redemptions, which doesn't move with the index; and a lag between when the index itself rebalances and when the fund manager can actually buy or sell to match it. A well-run large-cap index fund typically keeps tracking error under 0.5% a year; a fund tracking a less liquid index, like a small-cap or international index, usually runs higher.