Tracking difference

Tracking difference is the gap between a fund's actual total return and the total return of its benchmark index over a specific period, usually measured over a full year. If an index gains a certain percentage over a year and the fund built to track it gains a slightly lower percentage, that shortfall is the fund's tracking difference for that period.

Tracking difference is driven mainly by costs, primarily a fund's expense ratio, since fees are subtracted directly from a fund's returns while the benchmark index itself has no fees at all. Other smaller factors can add to or partially offset this drag, including the cash a fund holds to manage daily creation and redemption activity, the timing of dividend reinvestment, and any extra income the fund earns from securities lending, which can occasionally cause a fund to trail its benchmark by less than its stated expense ratio would suggest.

Tracking difference is often confused with tracking error, but the two measure different things. Tracking difference looks at the cumulative gap in actual returns over a period, essentially answering how much return was given up, while tracking error measures the volatility or consistency of that gap over time. A fund can have a small, stable tracking difference every year, or a similar average tracking difference made up of inconsistent year to year swings, and the two situations say very different things about how reliably the fund replicates its benchmark.