Tracking error measures the difference between the returns of a mutual fund and its benchmark index. It helps investors evaluate how closely a fund follows its benchmark.

Tracking error is calculated as the standard deviation of the difference between a fund’s returns and its benchmark’s returns over a specific period.

A tracking error occurs because of expense ratios, cash holdings, portfolio drift, and trading costs and taxes.

A low tracking error indicates that the fund closely follows the benchmark (ideal for index funds) whereas a high tracking error suggests significant deviation from the benchmark (active management impact).