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The difference in performance between a portfolio or fund and its benchmark index, measuring how closely a fund replicates the index it is designed to follow.
For index funds and ETFs, tracking error should be as small as possible. A fund tracking the S&P 500 with a tracking error of 0.05% closely follows the index, while a tracking error of 1% suggests meaningful deviation. Sources of tracking error include expense ratios (the fund's fees drag on returns), cash drag (holding uninvested cash), sampling (holding a subset rather than all index constituents), and rebalancing timing. When comparing index funds, lower tracking error is generally better because it means the fund more faithfully delivers the index return you are paying for.