Economic tracking error

What Is Economic Tracking Error?

Economic tracking error refers to the deviation between the actual performance of an economic variable or a financial portfolio and its intended benchmark or forecast. It is a crucial concept within Macroeconomic Analysis and Investment Performance measurement, indicating how closely an outcome matches its target. While most commonly associated with how well an Exchange-Traded Fund (ETF)) or Mutual Fund replicates its Benchmark Index, Economic Tracking Error can also apply to the discrepancies between economic forecasts and actual economic data, or the divergence of economic policies from their stated objectives. A lower Economic Tracking Error signifies a more accurate replication or more precise forecasting, reflecting greater efficiency or predictive power.

History and Origin

The concept of tracking error broadly emerged with the growth of indexed investing, particularly in the latter half of the 20th century. As Passive Investing gained prominence, investors sought ways to measure how effectively a fund mirrored its chosen index. The idea was simple: if an investment vehicle aimed to replicate a market index, any deviation from that index's Returns represented a "tracking error." Over time, this concept extended beyond pure financial replication to encompass any form of deviation from an expected or targeted path. In macroeconomics, while not always explicitly termed "economic tracking error," the analysis of discrepancies between projections and actual economic outcomes has always been fundamental. For instance, the Federal Reserve regularly assesses the performance of its economic forecasts, analyzing how actual Inflation and unemployment rates diverge from their projections. An Economic Letter from the San Francisco Fed, for example, highlights how forecast errors for inflation from the Federal Open Market Committee (FOMC) have varied, consistently overpredicting actual inflation from 2012 through 2020 and then underpredicting from 2021 onward.⁴

Key Takeaways

• Economic Tracking Error quantifies the divergence between an actual economic outcome or portfolio performance and its target or benchmark.
• In investment management, it measures how closely a fund replicates its benchmark index, with lower error indicating better replication.
• In macroeconomics, it can describe the accuracy of economic forecasts or the effectiveness of Monetary Policy in achieving targets.
• Factors like management fees, trading costs, and the fund's replication strategy can contribute to Economic Tracking Error in financial products.
• A high Economic Tracking Error in a financial product can indicate inefficiencies, higher costs, or an inability to closely follow the intended strategy.

Formula and Calculation

Economic Tracking Error, particularly in the context of investment portfolios, is typically calculated as the Standard Deviation of the difference between the portfolio's returns and its benchmark's returns over a specified period. This measures the Volatility of the excess returns.

The formula is expressed as:

Where:

• (\sigma) represents the standard deviation.
• (R_p) is the return of the portfolio over a given period.
• (R_b) is the return of the benchmark over the same period.

This calculation provides a single number that reflects the consistency of the portfolio's deviation from its benchmark. A Morningstar glossary entry defines tracking error as "the volatility of the difference in returns between a fund and its benchmark."³

Interpreting the Economic Tracking Error

Interpreting Economic Tracking Error depends heavily on the context. In Portfolio Management, a low tracking error generally indicates that a fund, particularly an index fund or ETF), is effectively replicating its chosen Benchmark Index. For passive investors, minimizing this error is paramount, as the goal is to match the index's performance as closely as possible, without significant deviation. Conversely, a higher tracking error suggests a greater divergence, which might be acceptable or even desired for actively managed funds aiming to outperform their benchmark, but undesirable for passive funds.

In a broader economic sense, a "low" Economic Tracking Error for a forecast implies high accuracy, while a "high" error suggests the actual economic outcome diverged significantly from predictions. This interpretation is crucial for policymakers and economists assessing the reliability of their models and the impact of their decisions.

Hypothetical Example

Consider an investor, Sarah, who owns an ETF) designed to track the performance of the Diversification Large-Cap Index. Over the past five years, the annual returns for the index and Sarah's ETF are as follows:

To calculate the Economic Tracking Error, we first find the series of differences between the ETF's returns and the index's returns: -0.5%, -0.2%, -0.3%, 0.1%, -0.3%.

Next, we calculate the standard deviation of these differences. Using a standard deviation calculator for this series (e.g., in a spreadsheet program), the standard deviation of these differences is approximately 0.22%. This 0.22% represents the Economic Tracking Error of Sarah's ETF relative to its benchmark over this five-year period, indicating a relatively tight tracking ability. This low tracking error suggests the Investment Strategy of the ETF is effective in replicating the index.

Practical Applications

Economic Tracking Error is widely applied across various domains of finance and economics:

• Index Fund and ETF Evaluation: For Passive Investing vehicles, tracking error is a primary metric used by investors to gauge how well a fund replicates its benchmark. A lower tracking error is generally preferred, as it indicates the fund is more faithfully delivering the index's performance. As noted by Monevator, a tracking error can reveal the "hidden cost" of owning a tracker if its returns consistently lag the benchmark by a significant margin due to expenses or other factors.²
• Active Management Analysis: While passive funds aim for zero tracking error, active managers intentionally deviate from a benchmark in pursuit of higher Returns. Here, tracking error is often referred to as "active risk" and is used in conjunction with "active return" to assess the manager's skill in generating excess returns relative to the risk taken.
• Risk Management: Portfolio managers use tracking error as a key risk metric to monitor how closely their portfolios align with investment guidelines or specific benchmarks. It helps ensure the portfolio's risk profile remains within acceptable bounds.
• Economic Forecasting: Governments, central banks (like the Federal Reserve), and economic institutions regularly publish forecasts for key economic indicators such as GDP, inflation, and unemployment. The deviation of actual outcomes from these forecasts can be considered an "economic tracking error," providing insights into the accuracy of models and the efficacy of Monetary Policy interventions.
• Hedge Fund Analysis: For hedge funds, tracking error can measure how much a fund's performance deviates from a relevant market index or a custom benchmark, providing insight into the fund's unique Investment Strategy and sources of return.

Limitations and Criticisms

While a valuable metric, Economic Tracking Error has limitations. One significant critique is that a low tracking error, while desirable for passive funds, does not necessarily guarantee superior performance. A fund could have a low tracking error by consistently underperforming its benchmark by a small, fixed margin (e.g., due to fees), still resulting in lower absolute returns for investors. Conversely, a high tracking error in an actively managed fund might signify a successful departure from the benchmark that leads to significant outperformance, rather than an "error."

Another limitation, particularly for Passive Investing, is that factors beyond a fund manager's control can contribute to tracking error. These include transaction costs incurred when rebalancing a portfolio to match an index, cash drag (cash holdings that don't earn index returns), and the inability to perfectly replicate an index with a vast number of securities, especially for illiquid assets. For example, a fund's expense ratio directly contributes to tracking error because index returns are not burdened by operating expenses.¹ Furthermore, different methodologies for calculating tracking error can lead to varying results, making comparisons between funds or forecasts challenging unless the calculation method is standardized.

Economic Tracking Error vs. Forecast Error

While closely related, "Economic Tracking Error" and "Forecast Error" are often used with slightly different emphases, though they share the core concept of deviation.

Economic Tracking Error typically refers to the deviation of a realized outcome (e.g., an investment portfolio's performance, actual inflation) from a defined benchmark or target. This benchmark can be a market index, a specific economic target set by policymakers, or a theoretical ideal. In the context of financial products, it measures how closely a fund's returns "track" its benchmark over time, often expressed as the standard deviation of the difference in returns. For broader economic phenomena, it describes the divergence from an expected or desired economic path, for instance, a government's actual deficit compared to its target.

Forecast Error, on the other hand, specifically measures the difference between a predicted value and the actual observed value of a variable. It is a direct measure of the accuracy of a prediction. For example, if a central bank forecasts 2% Inflation for the year, but actual inflation turns out to be 3%, the forecast error is 1%. While a forecast error contributes to or is a component of Economic Tracking Error when the benchmark is the forecast, the term "forecast error" is narrower, focusing solely on the accuracy of the prediction itself rather than the broader concept of tracking a pre-defined objective or index. Both concepts are vital for assessing the effectiveness of Risk Management and decision-making in both financial and macroeconomic contexts.

FAQs

What causes Economic Tracking Error in a passive fund?

Several factors can cause Economic Tracking Error in a Passive Investing fund, including management fees and operating expenses, transaction costs from buying and selling securities, cash holdings that aren't fully invested, the fund's inability to hold every security in its Benchmark Index (especially for large or illiquid indexes), and differences in dividend reinvestment policies.

Is a high Economic Tracking Error always bad?

Not necessarily. While a low Economic Tracking Error is desirable for passive funds aiming to replicate an index, a high tracking error for an Active Management fund might indicate that the manager is taking significant, intentional deviations from the benchmark in an attempt to generate higher Returns (also known as "active risk"). The "badness" depends on the fund's stated objective and whether the deviation leads to desired outcomes for the investor.

How is Economic Tracking Error different from Volatility?

Volatility measures the degree of variation of a security's or portfolio's returns around its own average. Economic Tracking Error, however, specifically measures the volatility of the difference between a portfolio's returns and its benchmark's returns. A portfolio can have high volatility but low tracking error if it moves very closely with a highly volatile benchmark.