Tracking error is a measure of how closely a portfolio follows an index – it is worked out by using the standard deviation of the portfolio’s returns relative to the benchmark. They are used as a measure of active risk. A high tracking error suggests the portfolio is more volatile than the index and a low tracking error suggests the portfolio is less volatile.
Index tracking or passive funds, which are designed to track an index should have low tracking errors. A sign that an active fund manager is not being active enough is a low tracking error, although it may also be a measure of his/her skill.