What It Means
Tracking error measures how closely an index fund or ETF's actual returns follow its benchmark index. A tracking error of zero would mean the fund's returns matched the index exactly, day for day; in practice every index fund has some tracking error, and a lower number means it's doing its one job, mirroring the index, more faithfully.
How It Works
Tracking error comes from a handful of real, unavoidable sources: the fund's expense ratio, which the index itself doesn't pay; a small cash buffer the fund keeps for redemptions, which doesn't move with the index; and a lag between when the index itself rebalances and when the fund manager can actually buy or sell to match it. A well-run large-cap index fund typically keeps tracking error under 0.5% a year; a fund tracking a less liquid index, like a small-cap or international index, usually runs higher.