Executive Summary

• Low tracking error does not always mean low conviction: In some cases, it reflects active risk that focuses specifically on stock-picking rather than volatile macro bets.
• Macro timing can be costly: High tracking error strategies often rely on sector, style, or country deviations that are hard to time and can lead to sharp losses, especially in environments of heightened economic uncertainty.
• A stable and consistent approach can pay off: A benchmark-aware, bottom-up approach focused on idiosyncratic stock selection can potentially deliver steady returns, higher information ratios, and less volatility across market cycles—all with relatively low tracking error.

Introduction

Tracking error measures the extent to which a fund’s returns “track” the performance of a benchmark. Viewed through this lens, high tracking error is often associated with high levels of purposeful, active risk-taking in pursuit of outperformance—a measure of a manager’s confidence in their positions or of the sophistication level of an investment process. Low tracking error, in contrast, is often associated with lower levels of investment insight and hence lower levels of conviction. In some cases, low tracking error can raise concerns about “closet indexing,” whereby a fund charges active management fees while delivering passive-like, benchmark-hugging performance.

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