Tracking error — what is it and why does it matter?

What is tracking error?

Tracking error is a measure of how much an ETF fund's performance differs from the performance of the index it's supposed to track. The lower the tracking error, the more faithfully the ETF replicates its benchmark.

Formally, it's the standard deviation of return differences between the fund and the index over a given period.

Tracking error vs tracking difference

These two concepts are often confused:

• Tracking difference — the total difference in returns between ETF and index in a given period (e.g., "ETF earned 9.8%, index 10.0% → tracking difference = -0.2%").
• Tracking error — the variability of this difference over time (whether the deviation is stable or jumps).

For a long-term investor, tracking difference is more important — it shows the real cost of holding an ETF.

What affects tracking error?

1. Management fees (TER) — the biggest component. ETF with 0.20% TER will have tracking difference around -0.20%.
2. Transaction costs — portfolio rebalancing costs money.
3. Replication method — synthetic (swap) ETFs usually have lower tracking error than physical ones.
4. Cash drag — the fund holds some assets in cash (for payouts), which doesn't earn.
5. Withholding tax on dividends — depending on the fund's domicile.
6. Securities lending — lending securities generates additional income, which reduces tracking difference.

Typical values

How to check?

• justETF.com — comparison of tracking difference for hundreds of ETFs.
• Fund factsheet — "Performance" section compares ETF with benchmark.
• KID — the document contains information about costs, which directly affect tracking.

How can Freenance help?

Freenance allows you to compare the actual performance of your ETFs with benchmarks. You can see if your fund is losing on replication — and how much it costs you in PLN.

👉 Compare your ETF performance — freenance.io