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We look at the difference between tracking difference and tracking error and how to use them to analyse passive funds.
This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.
Passive investing is one of the simplest and easiest ways to invest in the stock market. Instead of trying to beat the index, passive funds simply aim to track its performance.
You'll likely come across two phrases when looking at investing in passive funds – 'tracking difference' and 'tracking error'. Both are used to describe the way a passive fund tracks its benchmark. Unhelpfully, they're often misused or used interchangeably which can be confusing.
We take a look at what each of the phrases mean and how they can be used to analyse passive funds.
This article isn't personal advice. If you're not sure if an investment is right for you, seek financial advice. All investments can fall as well as rise in value, so you could get back less than you invest.
Tracking difference is a passive fund's performance compared with its benchmark over a certain period. It tells you the extent to which a fund has over or underperformed its benchmark.
For example, if a benchmark returned 10% over a year and the fund returned 9.98%, then the tracking difference for that period would be -0.02%.
Because a fund's total return includes fund expenses, tracking difference is usually negative for passive funds.
Tracking error gives us the consistency of a passive fund's tracking difference over the same period of time. It measures the extent to which a passive fund's return differs from its benchmark. It's the annualised standard deviation of the tracking difference data points for the given time period.
As tracking difference measures the performance of a fund versus its benchmark, it's often influenced by things like:
Tracking error on the other hand can be influenced by:
When it comes to measuring fund performance, ultimately investors are more interested in tracking difference than tracking error. That's because tracking difference is what affects the total return you receive on your investment and would indicate how well the fund's done in returning the same performance as its benchmark.
However, tracking error is still important. A high tracking error could indicate that future tracking difference could be high too, so it's always worth paying attention to when looking at passive funds.
The best passive fund would have both a low tracking difference and a low tracking error.
Remember as with any investment there are no guarantees and past performance is not a guide to the future.
If you want to learn more about passive funds, take a look at our Help & Support.
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Our fund research is for investors who understand the risks of investing and that investing in funds isn't right for everyone. Investors should only invest if the fund's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of a fund before they invest, and make sure any new investment forms part of a diversified portfolio.
This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.
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