The tracking error ratio offers us data on the profitability differential between a Investment fund and its benchmark or benchmarking for a specified period of time. It is often used to compare index funds against their benchmark stock index.
How is the tracking error calculated?
Its calculation formula is the following:
Tracking error = σ (Return of the fund - Return of the reference market index)
Where: σ: standard deviation
If after calculating this ratio, we obtain a high tracking error, we can indicate that the fund's profitability has been achieved by assuming more risks with respect to the benchmark index. It leads us to the fact that we have had a bad management because the index funds have not known how to copy their reference. Therefore, this ratio measures the degree to which the strategy differs from the index or the benchmark.
In other words, it measures the extent to which the fund manager has deviated from the benchmark. The measure will be useful in the performance evaluation that is carried out: if the active return or profitability is higher according to the active risk, the better the situation in which we find ourselves will be.
However, in addition to taking the tracking error into account, we also have to take into account other variables in its calculation. These variables are the fund's commissions compared to the competition if one is going to choose one index fund or another. It is obvious that the lower the commissions, the more profitable the investor will have.