Tracking error

Tracking error is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark. This is often in the context of a hedge fund, mutual fund, or exchange-traded fund (ETF) that did not work as effectively as intended, creating an unexpected profit or loss. Tracking error can have two meanings: Both definitions are measures of how closely an index fund or ETF follows the index to which it is benchmarked. Tracking difference is calculated by substracting the fund's net asset value (NAV) return from the index return for the same period; typically both of these numbers can be found on the fund sponsor's website. The most obvious source of tracking difference is the management expense ratio (MER). But factors such as currency hedging, cash drag, poor sampling, changes to the underlying index, index reconstitution, securities lending, and "fair value pricing" can play a role too. .
 * 1) the difference between the index total return and the total return of the fund -- this is also known as "tracking difference", or sometimes the "excess return" if the definition is reversed (total return of the fund minus total return of the index) ; or
 * 2) the "annualized standard deviation of daily return differences between the total return performance of the fund and the total return performance of its underlying index" (see also Wikipedia: tracking error).

A review of 2013 excess returns and tracking errors for several categories of index ETFs is available from National Bank Financial. Note that despite their attractive name, "excess returns" are almost always negative, i.e. the funds return less than their benchmarks.