What is implied by having a higher tracking error?

The concept of tracking error refers to the deviation of an investment's return from the return of a benchmark index. A higher tracking error indicates that the investment is showing greater variability in its performance compared to the benchmark. This divergence can be a result of active management strategies, where portfolio managers intentionally choose investments that differ from those in the benchmark in hopes of generating higher returns or achieving specific investment objectives.

In this context, greater divergence from the benchmark means the investment's returns are not closely following the benchmark's returns, leading to a higher tracking error. This could signal that the portfolio is taking on more active risk, as it is intentionally moving away from the benchmark's composition and performance. Thus, a higher tracking error suggests a more aggressive investment approach that might yield higher risk, but also the opportunity for higher returns, depending on market conditions and the effectiveness of the management strategy.