Tracking error is another measure of risk. In contrast to volatility, which measures fluctuation of absolute returns, tracking error measures the fluctuation of a difference, namely the difference between the return on the portfolio and the return on a benchmark observed on a monthly basis.
 

A tracking error may arise if a portfolio manager does not simply invest in a benchmark but deviates systematically from that benchmark. The tracking error measures the risk incurred by the portfolio manager due to deviations from the benchmark.
 

If the portfolio manager on average is able to earn 2 percentage points in excess of the benchmark and the tracking error is 3 percent, then the monthly excess returns with a probability of 95 percent are likely to fluctuate in a band of two standard deviations about the mean, that is between plus 8 and minus 4 percent.

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