Tracking error is the volatility of the return differences between a strategy and the Combined it belongs to — the standard deviation, period over period, of how far the strategy's return strays from its parent Combined's return. It measures a strategy against its parent Combined, not against a benchmark: the common assumption that tracking error is always measured versus a benchmark does not apply here.
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 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.
How does Fincanva handle it?
- Reported on the Strategy analytics page only, in its Each strategy, against the Combined card: one bar per strategy in the Tracking error column. A strategy analysed on its own still appears there, but it has no parent Combined to be measured against, so its tracking error carries no meaning — read it 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.
What does it look like in practice?
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.
A tracking error is not a limit on how far a strategy can diverge in future.