He loves spontaneity but is a control freak at the same time. I Investing. Tracking errors and how they arise Before we talk go further into the analysis, it is important to understand how ETFs work. Tracking error measures the variability of the return relative to the benchmark.
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Your Money. Personal Finance. Your Practice. Popular Courses. What Is a Tracking Error? Key Takeaways Tracking error is the difference in actual performance between a position usually an entire portfolio and its corresponding benchmark.
The tracking error can be viewed as an indicator of how actively a fund is managed and its corresponding risk level. Evaluating a past tracking error of a portfolio manager may provide insight into the level of benchmark risk control the manager may demonstrate in the future. Article Sources. Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts.
We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy. Compare Accounts. The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace. Related Terms Direct Indexing Definition Direct indexing involves purchasing the underlying shares of an index, rather than owning an index fund or ETF.
Index Funds: How They Work, Pros and Cons An index fund is a pooled investment vehicle that passively seeks to replicate the returns of some market indexes.
The Information Ratio Helps Measure Portfolio Performance The information ratio IR measures portfolio returns and indicates a portfolio manager's ability to generate excess returns relative to a given benchmark. Active Risk Active risk is a type of risk that a fund or managed portfolio creates as it attempts to beat the returns of the benchmark against which it is compared. What Is Relative Return? Relative return is the return an asset achieves over a period of time compared to a benchmark. An ETF usually trails its benchmark index, but can be in positive territory if it outperforms its index as a result of revenue from stock lending, for example.
It is important to look at tracking difference because it might eat into potential returns even more than fees as demonstrated in the chart below. However, funds also publish a separate metric that represents another factor that investors should consider: tracking error.
It is calculated by using the annualised standard deviation of the difference in the portfolio and the benchmark returns. If you need to decide which is more important, think about your investment time horizon.
If this a long-term investment, then tracking difference is likely to be more important than tracking error as you try to compare funds. If you anticipate needing access to your invested capital in the near term or you do not plan to hold your investment for the long term, tracking error could become more relevant.
In general, the closer to zero for both indicators, the better a passive ETF has replicated its underlying index. However, for most passive ETF investors tracking difference is likely to be the most important metric and is frequently used by ETF data providers as an important criterion for ranking funds. He added that tracking error was relatively unimportant for the long-term investor. Both criteria are among a much longer list of checks that investors should be making at least once a year, he advised.
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