What is tracking error?

How closely an index fund actually follows its index — and why gaps appear.

An index ETF's job is to match its index. Tracking difference is the gap between the fund's return and the index's return over a period; tracking error, strictly, is the volatility of that gap. Both measure execution quality.

Gaps come from the expense ratio (a constant drag), trading costs when the index changes, cash held for distributions, securities-lending income (which can offset costs), and, for international funds, taxes withheld on foreign dividends.

A well-run large index fund typically lags its index by roughly its expense ratio. A fund that lags by much more than its fee — or that swings around the index — deserves a closer look at how it is managed.