This refers to the difference between the returns on an investment portfolio and a benchmark that it is ideally supposed to imitate. The presence of the tracking error is attributed to different factors, including the costs involved in the periodic buying and selling of securities in order to rebalance a portfolio. Mutual funds that try to mimic the performance of an index, for instance, may have to sell or buy some stocks after a few quarters. This is because the index itself is often reconstituted based on the market capitalisation of stocks. Such shuffling of a portfolio involves costs like brokerage and taxes which in turn leads to the tracking error.
