What is Tracking Error?
Tracking Error (TE) measures how much a fund's daily returns deviate from its benchmark's daily returns. Low TE means the fund closely follows the index. High TE means the fund's returns are quite different from the benchmark on a day-to-day basis.
How We Compute TE
Daily TE = StdDev(excess_return) [sample std dev]
Annualized TE = Daily TE × √252
We annualize by multiplying by √252 (not 252), because standard deviation scales with the square root of time.
What is Information Ratio?
Information Ratio (IR) = excess return / tracking error. It tells you how much active return you get per unit of active risk. Higher is better. It's essentially the Sharpe Ratio but against the benchmark instead of the risk-free rate.
How We Compute IR
Numerator annualizes the mean daily excess return. Denominator is the annualized TE.
Worked Example
Active fund vs index fund
Active fund: TE = 5.8%, IR = 0.45
Index fund: TE = 0.3%, IR = −0.10
The active fund deviates significantly from the benchmark (5.8% TE) but generates positive excess return per unit of deviation (IR 0.45). The index fund barely deviates but slightly underperforms due to tracking costs.
How to Interpret
- TE < 2%: Essentially an index tracker
- TE 2-6%: Moderate active management
- TE > 6%: Highly active, concentrated bets
- IR > 0.5: Very good active management
- IR 0-0.5: Positive but modest active return
- IR < 0: Active bets are hurting - worse than just buying the index
Related metrics
More Risk Metrics methodology from the MFPRO analytics tool: