In a recent Morningstar interview, the firm’s director of manager research, Russ Kinnel, defines tracking errors and discusses how they relate to mutual funds.
Kinnel differentiates tracking error from standard deviation, which “tells you the absolute amount up and down.” Tracking error, he explains, tells investors about “volatility in a fund that’s not explained by its index’s movement.” Lower tracking error, he says, means that the fund “tends to hew pretty close to the index in terms of its performance. If the tracking error is higher, it means that the fund is all over the place and maybe doing something that’s quite different from the index.”
As far as how tracking error information should factor into portfolio management, Kinnel says, “I don’t really think high or low is necessarily bad; it’s how you use it in a portfolio. Low tracking error is a little more predictable, but it also depends on, do you already index funds. If you’ve got a couple of big holdings in index funds, maybe you don’t need anything else with a low tracking error that’s in a similar area.”