Costs Income and Total Return · ETFs

Tracking difference measures a return gap. Tracking error describes how variable that gap is. They reveal different parts of an index fund's behaviour.

Define the sign convention

In this guide, tracking difference means fund return minus benchmark return over the same period. A fund returning 7.7% against 8.0% has a difference of negative 0.3 percentage points. Other reports may reverse the sign, so read their definition before comparing. Use NAV total return for implementation analysis and market price return when assessing exchange trading outcomes.

Measure variability separately

Tracking error is commonly the annualised standard deviation of periodic fund returns minus benchmark returns. It measures consistency, not the average size of underperformance. A fund could lag by a small steady amount and have low tracking error. Another could have a similar average gap but much larger positive and negative deviations. Frequency, sample length and annualisation conventions affect the number.

Explain the gap before ranking funds

Fees, taxes, cash, sampling, trading, securities lending and benchmark treatment can contribute. Some effects offset others. A low expense ratio does not ensure the smallest realised gap. Compare like for like periods, share classes, currencies and total return definitions. Avoid comparing a new fund's six month record with another fund's five year result.

Use a practical research sequence

Start with the correct benchmark and record returns over matching dates. Review the annual gap, then consistency across shorter observations. Read the report for changes in method, taxes or portfolio implementation. If a fund suddenly diverges, check for distributions, split adjustments or stale data before concluding that its management failed. A measured tracking record is evidence about execution, not a guarantee of future performance.

Try it yourself

Fund A lags its benchmark by nearly the same amount every month. Fund B alternates between large positive and negative gaps. Can Fund B have similar average tracking difference but higher tracking error?

Show the worked answer

Yes. The average gap can be similar while the variability of periodic gaps differs greatly.

Further reading

Educational material, not a recommendation to transact. All numerical examples are hypothetical and exclude costs unless stated. Actual terms, eligibility, tax treatment and broker procedures depend on the security and jurisdiction.

Continue learning