Investment- Tracking Error and Information Ratio 

The tracking error of a fund reveals how the performance of the fund deviates from the performance of its benchmark. The tracking error so informs you how much active risk the manager took. 

The tracking error is measured by taking the standard deviation of the discrepancies between the returns on the fund and the returns on its benchmark. The bigger these variances, the more active risk was taken and the worse the tracking inaccuracy. A passive fund may be expected to have a very low tracking error relative to its benchmark index because the management is aiming to duplicate an index. But for an actively managed fund, the tracking error should be larger.  

Tracking error can also be utilized to build another widely used reward-to-risk ratio known as the information ratio. The information ratio tells you how much benefit a manager generated given the amount of active risk they took relative to the benchmark. In other words, did a manager’s wagers against the benchmark pay off? The ‘reward’ element of the information ratio is the difference between the total return of the fund and the return of an applicable benchmark index over the same period. The ‘risk’ element of the information ratio is based on the tracking error of the fund — that is, its departure from the performance of the benchmark. It is calculated as follows: