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Can someone provide me the formula for calculating the tracking error.

Tracking error is a general term for differences between a portfolio return and a benchmark, or sometimes a derivative and a hedge position. It can be measured by standard deviation, mean absolute deviation or other statistics. The frequency of observation is also important.

Thanks Aaron.Would the following description be correct.First the difference between returns on the benchmark, say, the Nifty index and the index fund is computed. The tracking error is the standard deviation of this difference. The tracking error is, therefore, the fluctuation in the differential returns between the index fund and its benchmark.

what you said is ex post tracking error.the formular for ex ante tracking error is different. you may refer to some book or simply search it online.

I agree except that there are other metrics for tracking error than standard deviation. Tracking error is the differences in return, although the name is also used for summary statistics about this difference. Standard deviation is the most common.As tigerbill says, ex ante tracking error is more complicated. It could refer to the distribution of the actual future tracking errors, or some statistics on that distribution.

One way to calculate tracking error quickly...(wCurrent - wBench) * CovarianceMatrix * (wCurrent - wBench)'where wCurrent is a row vector of current weight allocations, and wBench is a row vector of benchmark weight allocations, CovarianceMatrix is needless to say your absolute covariance matrix.