Tracking error

Also seen as: active risk, tracking risk

How is tracking error calculated?

Tracking error is the standard deviation of the difference between the strategy's return and its parent Combined's return in each period. A strategy that moves almost in step with the whole produces small, steady differences; one that often diverges produces wide, variable differences. The daily return differences are annualised by multiplying by √252 (252 trading days a year), the same convention Fincanva uses for volatility and the Sharpe ratio.

where $r_{\text{strategy}} - r_{\text{parent}}$ is the per-period gap between the strategy's return and the return of the Combined it sits inside, and the daily differences are annualised by ×√252.

What counts as a high tracking error?

A low tracking error means the strategy moves closely in line with its parent Combined; a high tracking error means it diverges from the whole. Neither is inherently good or bad — the value tells you how much a given strategy pulls the Combined away from its own average path.

Defaults in Fincanva

• Reported on the Strategy analytics table only, as the Tracking error column — one row per strategy inside a Combined. A strategy analysed on its own still gets a single row on that table, but it has no parent Combined to be measured against, so its tracking-error cell carries no meaning — read the column only for a strategy inside a Combined.
• Measured between a member strategy and its parent Combined — the strategy's return relative to the whole, not relative to a benchmark.
• Reported as the standard deviation of the daily return differences, annualised by ×√252 — the same convention as volatility and the Sharpe ratio.
• Pairs with the information ratio, which divides a strategy's excess return over the Combined by this tracking error.

Worked example

A Combined holds three strategies. Two of them tend to move closely with the Combined as a whole; the third often zigs when the Combined zags. Month to month, the third strategy's return differs from the Combined's by a wide, shifting margin, while the first two barely differ at all. The standard deviation of those monthly differences — much larger for the third strategy — is its tracking error. A high tracking error flags the strategy that pulls the Combined around the most, independent of whether that strategy made or lost money.

These figures describe what a strategy would have done on historical data, not what it will do, and a tracking error is not a limit on how far a strategy can diverge in future. Fincanva provides no financial advice — see Is this financial advice?.