Tracking Error

Tracking Error (TE) is the volatility of the active return — the portfolio return minus the benchmark return — annualised. It quantifies how far an active manager can drift from the benchmark. A truly index-tracking ETF has TE close to zero; an unconstrained active manager has TE in the 4-8% range; a long-short hedge fund might have TE of 15% or higher.

Formula

TE = stdev( R_p − R_b ) × √252      (annualised)

Sometimes computed as the standard deviation of the ε residuals in the CAPM regression — the two definitions coincide when β = 1.

Why TE matters

• ·It bounds the worst-case drift from benchmark: roughly 2× TE is the 95% one-year confidence interval.
• ·It is the denominator of the Information Ratio (IR = α / TE), the canonical "alpha per unit of active risk" measure.
• ·Institutional mandates use it to constrain managers — a Pension fund "TE budget" of 2% caps how far the manager can deviate.

TE thresholds in practice

• ·TE < 0.5% — pure index tracking. Anything more is implementation slippage.
• ·TE 0.5-2% — "enhanced" indexing or tilted passive.
• ·TE 2-6% — typical active long-only.
• ·TE > 8% — high-conviction concentrated or long-short.

How MEDGE Capital uses Tracking Error

TE is reported in the Compare report next to β, α and R² — the four numbers that summarise the relationship between a portfolio and its benchmark. The Information Ratio (α / TE) is derived and shown beside Sharpe and Sortino so the user can rank strategies on active-risk efficiency.