Tracking Error is the measure of how closely a portfolio follows the index to which it is benchmarked. It measures the difference between the portfolio returns and index returns. Tracking Risk is the risk that a relative return portfolio may not track its benchmark closely.

The terms "tracking error" and "tracking risk" are used by investment managers with a relative return objective. Relative return portfolios (or funds) seek to track closely to, or beat, a benchmark index.

It's important to realize that a 20% cash position in a relative return portfolio is considered risky even if the market is falling. A benchmark index like the S&P 500 or the Dow Jones Industrial Average always has 100% exposure to the stocks in the index. If a portfolio manager is trying to match or beat that index, the manager is at risk if his or her exposure to the stocks in the index is less. To them, this is considered a risk even if the stocks in the index falls. A 20% cash position may have reduced the loss of capital, but they consider it a risk since it may cause their performance to stay from the index. Specifically, they are mostly concerned about the risk of missing the upside if they are holding more cash than their benchmark. Since a relative return manager typically relies on exposure to the market (beta) to generate relative returns, if they stray to far in their exposure they consider it a tracking risk.

A true absolute return objective, as we see it, would define risk very differently. I define risk as the exposure to the possibility of loss. To manage or control risk, then, we increase and decrease the exposure the the possibility of a loss. For me, a reduction of 20% exposure to stocks is a risk control function. In a falling market, less exposure to falling prices is the reduction of risk.