What is the formula for tracking error?

The formula for tracking error is indeed the standard deviation of the difference between the portfolio returns (Rp) and the benchmark returns (Rbenchmark). Tracking error measures how closely a portfolio follows its benchmark index. It quantifies the variability of the excess returns that a portfolio generates over that benchmark.

When calculating tracking error, the first step is to determine the active return, which is defined as the return of the portfolio minus the return of the benchmark for corresponding time periods. The variability of this active return is then captured by calculating the standard deviation of these differences over a specified period. A smaller tracking error indicates that the portfolio is closely tracking its benchmark, while a larger tracking error suggests a greater divergence from the benchmark.

This concept is crucial for portfolio managers and investors who wish to understand the relative performance of their investments as compared to a benchmark. Tracking error provides insights into the risk associated with deviating from benchmark returns, helping inform investment strategies. Other options, while related to performance measurement, do not accurately describe tracking error as it is conventionally defined in financial analysis.