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Tracking error

What is tracking error?

A common misconception is that a stated tracking error means you'll underperform by that amount every year. Tracking error can work in your favor just as easily as against it.

Tracking error is technically a standard deviation. It measures how much your direct index's performance might differ from its benchmark. Based on historical simulations of a classic S&P 500 direct index, the observed tracking error was about 0.77% per year, meaning returns fell within roughly that range of the benchmark, in either direction, about 68% of the time.

A 140/40 Long short index has shown higher tracking error in Frec's simulations, around 1.5%, alongside roughly 3x the loss-harvesting potential of a classic index and the opportunity for pre-tax outperformance (an expected excess return above the benchmark, rather than just a symmetric range around it).

These are hypothetical results. They don't reflect actual customer outcomes and aren't a guarantee of future performance.

What benchmark is used for my strategy?

We compare your portfolio to an ETF that tracks the same or a similar index. For most strategies, that ETF invests in the exact index you're tracking. A few more specialized or international indices don't have a matching ETF, so we use the closest available proxy instead. This naturally means a larger expected tracking error for these:

  • S&P Developed Markets ADR
  • S&P Emerging Markets ADR
  • S&P 500 Shariah
  • S&P 500 Info Tech (same holdings, slightly different methodology)
  • MSCI ACWI ADR
  • MSCI EAFE ADR
  • MSCI World ADR

Other factors that affect tracking error

Customizations

Adding, removing, or reweighting a stock or sector changes your portfolio without changing the benchmark ETF. The bigger the customization, the bigger the potential gap.

Recent trading activity or wash sale restrictions

If your account is within a 30-day wash sale window (for example, right after initial funding or a recent transition), the algorithm can't yet buy back positions it recently sold at a loss without triggering a wash sale. New cash gets invested into whatever's currently eligible, rather than your target mix. This can widen tracking error temporarily, and it typically narrows again once the window clears and the algorithm brings you back in line.

AUM fees and transaction costs

Frec's fee is billed monthly. The benchmark ETF's expense ratio is deducted daily, with different timing and, sometimes, different amounts. Trading costs (bid-ask spread and regulatory fees) can add a small amount too, estimated at around 0.02% based on Frec's research.

Timing of dividend reinvestment

ETFs typically reinvest dividends monthly or quarterly. Frec reinvests dividends from your underlying stocks as soon as they're received. This timing difference can nudge tracking error either way.

Corporate actions

Some positions in your index undergo a corporate action. Learn more about corporate actions. Differences in how your portfolio and the underlying ETF handle these changes can also lead to a larger tracking error.

Where can I view my tracking error?

  1. Open your direct index details page and go to the performance graph.
  2. Select Compare to ETF.
  3. Hover or tap on the graph to see your tracking error against the benchmark.

You can also adjust how your account balances tracking versus tax-loss harvesting in your tracking preference settings.