Tracking Error
Definition
The standard deviation of the difference between a portfolio's returns and its benchmark's returns.
Explanation
Tracking error measures how consistently a manager deviates from the benchmark. An index fund has tracking error near zero. An active manager with tracking error of 5% generates returns that differ from the benchmark by an average of 5% per year. Low tracking error with positive alpha = high information ratio = efficient active management. High tracking error with negative alpha = the manager is taking active risk but destroying value. Tracking error helps investors understand whether 'active' management is truly active or merely a closet index.
Formula
Tracking Error = σ(Rp - Rb)