I'm looking at a variety of index funds. I know that tracking error, loosely speaking, is the deviation of a fund's performance from that of the underlying index. I know lower is better, but I can't find any information on how high of a tracking error is acceptable. Is there such a limit or is 'too high' too subjective a criterion? Or am I looking at the wrong stat?

Edit to clarify I'm in the Philippines and can only in invest in Philippine funds.


I don't think there is a universal rule of thumb about an acceptable amount of tracking error because some indices are harder to track than others. Vanguard defines tracking error as:

the annualized standard deviation of excess return data points

Certain funds are easy to track (i.e. the S&P 500 index) and should have virtually no tracking error. Some tracking error is more acceptable for an esoteric index that's difficult to track. According to the New York Times the average tracking error of all ETFs in the US was 59 basis points (they're using a different definition of 'tracking error' than Vanguard):

The average tracking error of all E.T.F.’s listed in the United States last year was 59 basis points, or slightly more than half of a percentage point, according to a study released last month by Morgan Stanley Smith Barney. For those E.T.F.’s with at least one year of trading history, Morgan Stanley compared the difference in total 2012 return between each fund and its underlying index.

Index funds are meant to track indices and limit tracking error. An 'acceptable' amount of tracking error depends on how easy it is to track an index. The whole point of indexing is to earn zero alpha (i.e. low tracking error) and it's worthwhile to avoid funds that unnecessarily deviate from their underlying indices.

  • I guess the next question is, how to determine ease of tracking. Equity indices should be fairly easy for a large fund to track, right? – jcm Jul 21 '14 at 3:05

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