Tracking error is a measure used to determine how closely a portfolio follows its benchmark index. It's the standard deviation of the difference between the returns of the portfolio and the returns of the benchmark. A lower tracking error indicates a closer alignment with the benchmark.
For investors in index funds or exchange-traded funds (ETFs), a low tracking error is desirable, as it signifies that the fund is closely replicating the performance of its benchmark. For active fund managers, tracking error can indicate the extent to which the fund deviates from the index, reflecting the manager's investment style and risk-taking level.
While tracking error is useful for assessing how well a fund or portfolio is matching its benchmark, it does not indicate whether the fund is outperforming or underperforming the index. Therefore, it should be considered alongside other metrics like relative return and fund management strategies.
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