Tracking Error: What Investors Need to Know in 2025

In the world of investing, few metrics are as revealing—and as misunderstood—as tracking error. As more Australians embrace index funds, ETFs, and active management strategies, understanding tracking error is crucial for evaluating how well your investments stick to their intended course. In 2025, with new regulatory standards and an explosion of passive products, tracking error is more relevant than ever for both retail investors and professionals.

What is Tracking Error?

Tracking error measures the difference between the returns of an investment portfolio and its benchmark index. Expressed as a standard deviation, it quantifies how consistently a fund manager replicates (or deviates from) their target benchmark. A low tracking error suggests the portfolio moves almost in lockstep with the benchmark, while a high tracking error indicates greater divergence.

• Low Tracking Error: Often seen in passive index funds or ETFs aiming to closely mimic a market index like the ASX 200.
• High Tracking Error: Typical in actively managed funds, where managers take significant bets away from the index to outperform it.

For example, if an Australian equity ETF aims to mirror the S&P/ASX 200 but consistently delivers different returns, tracking error quantifies this gap, helping investors assess whether the fund is delivering what it promises.

Why Does Tracking Error Matter in 2025?

Regulatory changes and evolving fund disclosures have made tracking error a headline metric in Australia this year. The Australian Securities and Investments Commission (ASIC) now requires greater transparency around performance reporting, including more rigorous disclosures of tracking error for managed funds and ETFs. For investors, this means:

• Clearer comparisons between similar products, especially in the booming ETF sector.
• Better risk assessment—a higher tracking error can signal that a fund is taking more active risks, which may or may not suit your investment goals.
• Fee justification—Active managers charging higher fees must now show whether their extra risk (as revealed by tracking error) is delivering outperformance, not just divergence.

Consider two superannuation funds: Fund A, an index-hugging option with a tracking error of just 0.3%, and Fund B, a more active fund with a tracking error of 2.5%. In 2025, new MySuper performance test updates require these funds to disclose tracking error figures in member communications, empowering Australians to make more informed choices about risk versus reward.

How to Use Tracking Error When Assessing Investments

Tracking error is not just a number to glance at—it’s a diagnostic tool for understanding a fund’s true behaviour. Here’s how to use it effectively:

1. Benchmark Appropriateness: Check whether the fund’s stated benchmark makes sense for its strategy. A misaligned benchmark can make tracking error figures misleading.
2. Compare Like-for-Like: Use tracking error to compare similar funds—such as two Australian equity index ETFs. The one with the lower tracking error is likely tracking the index more precisely.
3. Weigh Fees Against Value: For active funds, ask if a higher tracking error (and higher fees) are justified by consistent outperformance, not just portfolio drift.
4. Risk Tolerance: Align tracking error with your comfort zone. If you prefer a “set and forget” approach, low tracking error products may be ideal. If you seek outperformance and are willing to accept bumps along the way, some tracking error may be desirable.

For example, in 2025’s competitive ETF market, the VanEck Australian Equal Weight ETF and the BetaShares Australian 200 ETF both track the ASX 200, but VanEck’s equal-weight approach leads to a higher tracking error—offering a different risk/return profile compared to the traditional market-cap weighted BetaShares fund.

Tracking Error in Practice: 2025 Trends and Takeaways

This year, several trends are reshaping how Australians view and use tracking error:

• More Sophisticated Investors: DIY superannuation investors are increasingly using tracking error data to choose low-cost ETFs and to scrutinise active fund performance.
• Enhanced Product Disclosure: ASIC’s new guidelines mean all major fund providers must report tracking error as part of their Product Disclosure Statements (PDS), making it easier to compare options at a glance.
• Performance Tests: APRA’s annual MySuper performance test now incorporates tracking error in the risk assessment, making it a factor in whether funds pass or fail the test.

Real-world example: In early 2025, a major Australian super fund was scrutinised for a tracking error of over 3% in its international equities option, despite being marketed as a “core index” product. Following member outcry and media coverage, the fund restructured its portfolio to align more closely with its benchmark, reducing tracking error to below 1% within two quarters.

Conclusion: Tracking Error as Your Investment Compass

Tracking error is no longer an obscure statistic buried in fund fact sheets—it’s a core tool for every Australian investor. Whether you’re picking a super fund, ETF, or active manager, understanding tracking error helps you align your investments with your goals and risk appetite. In 2025’s more transparent and competitive investment landscape, use tracking error to make smarter, more informed choices—and keep your portfolio on track.