Tracking error is the extent to which a portfolio’s performance differs from the performance of the benchmark to which it’s being compared.
For example, if you own an index fund (or ETF) and you find that it’s not tracking its index very closely, then the fund is exhibiting tracking error. And, yes, you should be concerned. It’s likely an indication that something is going wrong.
Tracking Error for a Portfolio
Tracking error can be said to exist at the portfolio level as well. For example, if the stock portion of your portfolio performs significantly differently in any given year than the performance of the U.S. stock market, that’s a form of tracking error (if you compare your portfolio’s performance to the market’s performance, that is).
As such, whenever you include things in your portfolio other than a typical total stock market fund, you increase tracking error. An allocation to REITs, international stocks, or a small-cap value fund, for example, would have that effect.
Of course, with each of those investments, the entire point is that they’ll perform differently from the overall U.S. market. (The idea being that their less-than-perfect correlation will result in lower overall portfolio volatility.)
So Who Cares About Tracking Error?
Perhaps you do.
Imagine this scenario: The market is up 10% for the year, but the stock portion of your portfolio is flat. And some of your holdings have lost 10% or more. Would that bother you? Would you be tempted to sell the investments that haven’t performed well recently?
Or what if the period of underperformance lasted for several years? Would you start to worry that your choice of investments was a mistake? If so, then you care about tracking error. And it might make sense for you to avoid it, because periods of underperformance will happen if you own anything other than a total stock market fund.
In and of itself, portfolio tracking error is not a problem. But it’s important to know yourself and your limitations. If periods of underperformance would bother you and potentially cause you to give up on a particular investment at exactly the wrong time, then perhaps you should stick with plain vanilla total market funds for the equity portion of your portfolio.