Tracking error

Tracking error captures how faithfully a passive fund reproduces the return of its benchmark index. Two related measures are used: tracking difference (the cumulative percentage gap between fund and index returns over a period) and tracking error in the strict sense (the standard deviation of the daily or monthly return differences).

Some tracking error is guaranteed by fund costs — every dollar of MER is a dollar of return the fund can't recover. Beyond fees, sampling (holding a representative subset of the index rather than every security), trading friction, cash drag, securities-lending revenue, and the mechanics of index reconstitution all contribute.

For a well-run broad-market ETF, the fund usually trails its index by roughly the MER, sometimes slightly less when securities-lending revenue offsets part of the cost. Larger gaps point to structural friction — illiquid underlyings, FX hedging, or complex index methodology.