Tracking Error Explained: A Guide for Australian Investors in 2026

As more Australians turn to index funds, ETFs, and managed funds, understanding how your investments perform relative to their benchmarks is increasingly important. One of the most useful tools for this is tracking error—a measure that helps you see how closely a fund follows its stated index or target. In 2026, with a growing range of investment products and greater transparency requirements, tracking error has become a central consideration for both new and experienced investors.

This article explains what tracking error is, why it matters, and how you can use it to make better investment choices in the current Australian market.

Tracking error measures the variability of the difference between a fund’s returns and the returns of its benchmark index. In simple terms, it tells you how much a fund’s performance deviates from the index it aims to follow. Tracking error is usually expressed as a percentage, calculated as the standard deviation of the difference between the fund and the benchmark’s returns over a period of time.

• Low Tracking Error: Indicates the fund’s returns are very close to the benchmark. This is typical for passive index funds and ETFs designed to mirror a specific index, such as the S&P/ASX 200.
• High Tracking Error: Suggests the fund’s returns differ more from the benchmark. This is often seen in actively managed funds, where managers make investment decisions that intentionally diverge from the index in pursuit of higher returns.

For example, if an Australian equity ETF aims to track the S&P/ASX 200 but its returns often differ from the index, tracking error quantifies this difference. A low tracking error means the ETF is closely following the index, while a higher tracking error means its returns are more unpredictable compared to the benchmark.

In 2026, tracking error is more relevant than ever for Australian investors. With a wider range of investment products and increased regulatory focus on transparency, tracking error is now a standard part of fund reporting. This makes it easier for investors to compare products and understand the risks involved.

Key reasons tracking error matters include:

• Transparency: Fund managers are required to disclose tracking error figures, making it easier for investors to see how closely a fund follows its benchmark.
• Risk Assessment: Tracking error helps you understand the level of active risk a fund is taking. A higher tracking error can indicate more active management, which may or may not align with your investment goals.
• Comparing Funds: Tracking error allows you to compare similar funds—such as two Australian equity ETFs—to see which one more closely tracks its index.
• Fee Considerations: For funds with higher fees, tracking error can help you decide if the extra cost is justified by the fund’s approach and performance.

Tracking error is a practical tool for assessing how a fund behaves compared to its benchmark. Here’s how you can use it when evaluating investment options:

1. Check the Benchmark

Before looking at tracking error, make sure the fund’s benchmark is appropriate for its stated strategy. If the benchmark doesn’t match the fund’s investment approach, tracking error figures may not provide meaningful insights.

2. Compare Similar Funds

When comparing funds with similar objectives, such as two Australian equity index ETFs, tracking error can help you see which fund is more closely aligned with its benchmark. Generally, a lower tracking error means the fund is doing a better job of tracking the index.

3. Assess Active Management

For actively managed funds, a higher tracking error is expected, as managers make investment decisions that differ from the benchmark. However, it’s important to consider whether the fund’s performance justifies the additional risk and fees associated with higher tracking error.

4. Match Tracking Error to Your Risk Tolerance

Your comfort with risk should guide your choice. If you prefer predictable returns that closely follow the market, look for funds with low tracking error. If you’re seeking the potential for outperformance and are comfortable with more variability, a higher tracking error may be acceptable.

Several trends are shaping how tracking error is used and reported in Australia this year:

• Greater Disclosure: Fund providers now include tracking error in their regular reports and product disclosure statements, making it easier for investors to access this information.
• Informed Investors: More Australians are using tracking error data to compare ETFs and managed funds, especially as the range of available products grows.
• Regulatory Focus: Regulatory bodies have increased their focus on transparency and risk reporting, making tracking error a standard metric in fund assessments.

These changes mean that tracking error is no longer just a technical term for professionals—it’s a practical tool for everyday investors to assess how well their investments are performing relative to their goals.

Several factors can contribute to tracking error in a fund:

• Management Fees: Fees and expenses can cause a fund’s returns to lag behind its benchmark.
• Portfolio Construction: Differences in how a fund is constructed compared to the index (such as holding fewer securities or using a different weighting method) can increase tracking error.
• Trading Costs: Costs associated with buying and selling securities can affect returns and contribute to tracking error.
• Cash Holdings: Funds may hold cash for liquidity, which can cause returns to differ from a fully invested index.
• Dividend Timing: The timing of dividend payments and reinvestments can also impact tracking error.

Understanding these factors can help you interpret tracking error figures and make more informed decisions.

While tracking error is a useful metric, it’s important to recognise its limitations:

• Does Not Measure Outperformance: Tracking error only shows how much a fund’s returns differ from the benchmark, not whether it is outperforming or underperforming.
• Short-Term Variability: Tracking error can fluctuate over short periods, so it’s best to look at figures over longer timeframes.
• Benchmark Relevance: If the benchmark is not appropriate for the fund’s strategy, tracking error figures may be misleading.

If you’re considering a new fund or reviewing your portfolio, here’s how to use tracking error in your decision-making process:

1. Review Fund Reports: Look for tracking error figures in product disclosure statements or regular fund updates.
2. Compare Across Similar Products: Use tracking error to compare funds with similar investment objectives.
3. Consider Your Goals: Decide whether you want a fund that closely tracks the market or one that takes more active risks.
4. Balance with Other Metrics: Use tracking error alongside other measures, such as fees, past performance, and investment strategy, to get a complete picture.

Tracking error is a valuable tool for Australian investors in 2026, offering insights into how closely a fund follows its benchmark and the level of risk involved. By understanding and using tracking error, you can make more informed choices about your investments, whether you prefer the predictability of index funds or the potential for outperformance with active management. As transparency and product choice continue to grow, tracking error will remain an essential part of the investment decision process.

What is a good tracking error for an index fund?
A low tracking error is generally desirable for index funds, as it indicates the fund is closely following its benchmark. However, what is considered "low" can vary depending on the fund and market conditions.

Does a higher tracking error mean higher returns?
Not necessarily. A higher tracking error means the fund’s returns differ more from the benchmark, but this could result in either higher or lower returns.

Can tracking error change over time?
Yes, tracking error can fluctuate due to changes in market conditions, fund management, or portfolio construction. It’s best to review tracking error over longer periods.

Is tracking error the only metric I should consider?
No, tracking error is just one of several important metrics. Consider it alongside fees, investment strategy, and past performance when making investment decisions.