Index Tracking Error Meaning: Definition, Calculation, Causes and Examples
Index Tracking Error Meaning: Definition, Calculation, Causes and Examples
Index funds and exchange-traded funds (ETFs) are designed to follow the performance of a particular market index. For example, an index fund tracking the Nifty 50 aims to deliver returns that closely correspond to the Nifty 50 benchmark.
However, a fund’s actual returns may differ from the index it follows. This happens because of fund expenses, transaction costs, cash holdings, changes in index constituents, and other operational factors.
This difference in how closely a fund follows its benchmark is an important consideration in passive investing. One metric investors use to evaluate this consistency is called tracking error.
Understanding index tracking error helps investors compare passive funds, evaluate how accurately they replicate their benchmarks, and make more informed investment decisions.
1. What Is Index Tracking Error?
Index tracking error measures how much the returns of an index fund or ETF fluctuate relative to the returns of its benchmark index over a specific period. In simple terms, it indicates how consistently a passive fund follows the index it is designed to track.
For example, suppose an index fund tracks the Nifty 50. Ideally, the fund should generate returns very close to the benchmark’s returns. However, its performance may vary slightly because the fund has operating expenses, may hold some cash, and may not always replicate every index transaction immediately.
Tracking error measures the variability of these differences over time. It is generally calculated as the standard deviation of the differences between the fund’s periodic returns and the benchmark’s corresponding periodic returns.
Important point: Tracking error does not simply measure the difference between a fund’s total return and the index’s total return. It measures how much the periodic return differences vary over the selected measurement period.
A lower tracking error generally indicates that the fund follows its benchmark more consistently. A higher tracking error indicates greater variation in its performance relative to the index.
2. How Does Index Tracking Error Work?
To understand tracking error, consider how an index fund operates. An index fund attempts to replicate the composition and performance of a selected benchmark.
If the benchmark contains 50 companies, the fund generally tries to hold those securities in proportions that reflect their index weights, subject to its investment strategy and applicable restrictions. However, perfect replication is not always possible.
For example:
- The fund may deduct operating expenses.
- It may hold some cash to meet redemption requests.
- It may take time to adjust holdings when the index changes.
- Some securities may have limited liquidity.
- Buying and selling securities may involve transaction costs.
These factors can cause the fund’s daily or periodic returns to differ from those of its benchmark. Tracking error measures the consistency of those differences.
Example:
Suppose an index and an index fund produce the following hypothetical daily returns:
| Day | Index return | Fund return | Return difference |
|---|---|---|---|
| Day 1 | 1.00% | 0.95% | -0.05% |
| Day 2 | -0.50% | -0.48% | 0.02% |
| Day 3 | 0.80% | 0.76% | -0.04% |
| Day 4 | -0.30% | -0.32% | -0.02% |
| Day 5 | 0.60% | 0.55% | -0.05% |
The fund does not generate exactly the same return as the index on every day.
The differences are relatively small in this illustration, but they vary from one day to another. Tracking error measures the standard deviation of these periodic return differences over the full measurement period.
The five observations above are only an educational example. A reliable annualised tracking error calculation requires an appropriate historical return series and the applicable annualisation method.
3. How Is Tracking Error Calculated?
Tracking error is generally calculated using the standard deviation of the differences between a fund’s periodic returns and its benchmark’s corresponding returns.
The basic formula is:
[ TE = SD(R_f-R_b) ]
Where:
- (TE) = Tracking error
- (SD) = Standard deviation
- (R_f) = Fund return for each period
- (R_b) = Benchmark return for the corresponding period
For daily return observations, the annualised tracking error is commonly calculated as:
[ TE_{annual}=SD(R_f-R_b)\times\sqrt{250} ]
Here, 250 represents an illustrative number of trading days in a year, commonly used for annualising daily equity-market observations. The applicable convention may differ depending on the market and methodology.
Step-by-step calculation
- Collect the fund’s NAV or price data for the selected period.
- Collect the corresponding benchmark return data.
- Calculate the daily percentage return for the fund and benchmark.
- Calculate the difference between their daily returns.
- Find the standard deviation of these daily return differences.
- Annualise the result using the applicable trading-day convention.
In India, NSE explains the calculation of tracking error using the standard deviation of the differences between an index fund’s returns and its benchmark’s Total Returns Index (TRI) returns.
The TRI is important because it includes the effect of dividends reinvested in the index, providing a more appropriate comparison for funds that account for dividend income.
4. Example of High and Low Tracking Error
Tracking error is generally expressed as an annualised percentage.
Consider two hypothetical funds that both track the same market index.
| Particulars | Fund A | Fund B |
|---|---|---|
| Benchmark | Same index | Same index |
| Annualised tracking error | 0.15% | 0.80% |
| Tracking consistency | Higher | Lower |
| Variation from benchmark returns | Lower | Higher |
Fund A has a lower tracking error than Fund B. This suggests that Fund A has followed the benchmark more consistently during the measurement period.
Fund B has a higher tracking error, meaning its periodic returns have varied more relative to the benchmark.
However, this does not automatically mean Fund A is a better investment in every respect. Investors should also consider tracking difference, expense ratio, liquidity, fund structure, and other relevant factors.
5. What Causes Index Tracking Error?
Several factors can cause an index fund or ETF to perform differently from its benchmark.
Understanding these causes helps investors recognise why even a passive fund cannot perfectly replicate an index at all times.
1. Fund expenses
Index funds charge operating expenses for managing and administering the scheme.
These expenses reduce the money available for investment and can cause the fund’s returns to differ from the benchmark.
Generally, higher recurring expenses can contribute to a larger negative return difference, although tracking error also depends on how consistently the difference occurs.
2. Cash holdings
Index funds may maintain a portion of their assets in cash or short-term instruments. Cash may be required to meet redemption requests, handle subscriptions, or manage operational requirements.
However, when the benchmark rises or falls, the cash portion may not move in the same way as the index securities. This can create a difference between the fund’s returns and benchmark returns.
3. Changes in index constituents
Market indices are periodically reviewed. Companies may be added, removed, or assigned different weights.
When the benchmark changes, the fund must adjust its portfolio accordingly. If you the fund cannot make these changes immediately or at the same prices used by the index calculation, its returns may temporarily differ from the benchmark.
4. Transaction costs
Buying and selling securities involves costs. These may include brokerage charges, bid-ask spreads, taxes, and market impact.
Such costs reduce the fund’s returns and can affect how closely it follows its benchmark.
5. Liquidity limitations
Some securities included in an index may not trade frequently.
If a fund cannot buy or sell a security at the required price or time, it may be difficult to maintain the exact portfolio composition of the benchmark. This can contribute to tracking error.
6. Corporate actions
Companies may announce events such as mergers, stock splits, rights issues, or dividend payments.
These events can require adjustments to the fund’s holdings and accounting. If the fund’s response does not match the benchmark’s treatment or timing, temporary differences may occur.
7. Portfolio replication method
Some funds use full replication, while others may use sampling or other permitted strategies.
- Full replication: The fund attempts to hold all or most of the securities in the index in their respective weights.
- Sampling: The fund holds a representative selection of securities intended to approximate the benchmark’s performance.
Sampling can reduce operational complexity in some circumstances, but it may also introduce differences between fund and index returns.
6. Tracking Error vs Tracking Difference
Tracking error and tracking difference are related concepts, but they measure different aspects of passive fund performance.
Tracking difference measures the actual difference between a fund’s return and its benchmark’s return over a specified period.
Tracking error measures the variability of the periodic differences between the fund’s returns and benchmark returns.
| Feature | Tracking error | Tracking difference |
|---|---|---|
| Meaning | Variability of return differences | Actual return difference |
| Measurement | Standard deviation | Difference between returns |
| Focus | Consistency of benchmark tracking | Overall relative performance |
| Interpretation | Lower generally means more consistent tracking | Smaller absolute difference generally means closer overall returns |
| Common use | Evaluating tracking consistency | Comparing fund and benchmark performance |
Example:
Suppose a benchmark generates a return of 12% over one year, while an index fund generates 11.70%.
The tracking difference for this period is:
[ 11.70%-12%=-0.30% ]
The fund has underperformed the benchmark by 0.30 percentage points.
However, this figure alone does not tell us the fund’s tracking error. To calculate tracking error, we need the series of periodic return differences over the measurement period.
A fund can have a small tracking difference but a relatively high tracking error if its periodic returns vary considerably. Similarly, a fund may have a consistent negative return difference but relatively low tracking error.
Therefore, investors should examine both measures rather than treating them as interchangeable.
7. Why Is Tracking Error Important for Index Fund Investors?
Tracking error is useful because passive investors generally choose index funds to obtain exposure to a particular benchmark.
If a fund consistently deviates from its benchmark, investors may not receive the market exposure they originally expected. Tracking error helps investors in several ways.
Evaluating fund performance
It provides information about how consistently a fund follows its benchmark.
Comparing similar index funds
Investors can compare funds tracking the same index to understand which has historically followed its benchmark more consistently.
Understanding implementation quality
Tracking error can help investors assess how effectively a fund manages portfolio replication and operational activities.
Identifying unexpected deviations
A significant increase in tracking error may encourage investors to examine whether fund expenses, liquidity conditions, index changes, or other factors have affected tracking performance.
Supporting investment decisions
When combined with other fund characteristics, tracking error can help investors make a more informed comparison between passive investment products. However, tracking error should not be used as the only basis for choosing a fund.
8. What Is a Good Tracking Error for an Index Fund?
A good tracking error is generally one that is relatively low compared with other funds tracking the same benchmark.
However, there is no single universal figure that makes every index fund good or bad.
The acceptable level can depend on:
- The type of index being tracked.
- The liquidity of its underlying securities.
- The fund’s size and structure.
- The fund’s replication method.
- Market conditions.
- The period and methodology used for measurement.
For example, a fund tracking a highly liquid large-cap index may be easier to replicate than one tracking a less liquid or more complex index.
How should investors interpret tracking error?
- Lower tracking error generally indicates more consistent benchmark replication.
- Higher tracking error indicates greater variation in relative returns.
- A sudden increase may justify further investigation.
- Comparisons are more meaningful when funds track the same benchmark and use comparable measurement periods.
Do not assume that a particular tracking error percentage is automatically acceptable for every fund. Evaluate it in the context of the fund’s benchmark and disclosures.
9. How to Check Tracking Error Before Investing
Investors can review tracking error before selecting an index mutual fund or ETF.
In India, useful sources include:
- Asset management company websites.
- Mutual fund scheme factsheets.
- AMFI’s tracking error and tracking difference information.
- Scheme information documents and other official disclosures.
AMFI provides a dedicated facility for checking tracking error and tracking difference.
When comparing funds, follow these steps:
1: Identify the benchmark
Confirm that the funds you are comparing track the same index.
2: Check the latest tracking error
Review the most recent disclosed figure and understand whether it is annualised.
3: Compare similar periods
Use comparable historical periods and measurement methods.
4: Examine tracking difference
Check whether the fund has consistently underperformed or outperformed its benchmark over longer periods.
5: Review the expense ratio
Consider whether fund expenses may be contributing to the difference in performance.
6: Understand the fund’s structure
Review its replication strategy, liquidity, investment restrictions, and other relevant characteristics. A single tracking error figure should not replace a broader evaluation of the fund.
10. Tracking Error in Index Funds vs ETFs
Both index mutual funds and ETFs can experience tracking error because both are designed to follow benchmarks. However, their operating structures differ.
Index mutual funds
Index mutual funds generally issue and redeem units based on the applicable NAV calculation.
Their tracking error may be affected by fund expenses, cash holdings, transaction costs, index changes, and portfolio replication.
Exchange-traded funds
ETFs trade on stock exchanges throughout market hours. Their tracking error at the fund level can be influenced by expenses, portfolio holdings, cash balances, liquidity, and other operational factors.
It is also important to distinguish an ETF’s NAV-based tracking error from the difference between its exchange-traded market price and the underlying index. The ETF’s market price can trade at a premium or discount to its NAV.
For a meaningful comparison of benchmark tracking, investors should examine the fund’s official tracking disclosures and understand which return series is being measured.
11. Limitations of Tracking Error
Although tracking error is a useful measurement, it has certain limitations.
It does not measure absolute investment risk
A low tracking error does not mean that an index fund is safe from market losses. If the underlying index falls sharply, the fund may also lose value while continuing to track it closely.
It does not guarantee future performance
Historical tracking error describes past tracking consistency. It does not guarantee that the fund will maintain the same level in the future.
It does not show the direction of underperformance
Tracking error measures variability, not whether the fund consistently performs better or worse than its benchmark.
Tracking difference is more useful for understanding the direction and size of the overall return gap.
It depends on the measurement period
Tracking error can change depending on the data frequency, observation period, and annualisation method.
It does not include every investor cost
Fund-level tracking error does not necessarily capture all costs an individual investor may experience, such as personal brokerage commissions, account fees, or taxes.
For these reasons, tracking error should be considered alongside other investment measures.
Frequently Asked Questions (FAQs)
1. What is index tracking error in simple words?
Index tracking error measures how much the periodic returns of an index fund or ETF vary from the returns of its benchmark index. A lower tracking error generally means the fund follows its benchmark more consistently.
2. What does a low tracking error mean?
A low tracking error indicates that a fund’s returns have followed its benchmark more consistently over the selected measurement period. It does not mean that the fund is free from market risk.
3. What does a high tracking error indicate?
A high tracking error indicates greater variation between the fund’s periodic returns and its benchmark’s returns. It may result from expenses, cash holdings, liquidity limitations, index changes, or other operational factors.
4. How is tracking error calculated?
Tracking error is calculated as the standard deviation of the differences between a fund’s periodic returns and its benchmark’s corresponding returns. Daily tracking error is often annualised using the square root of the applicable number of trading days.
5. What is the difference between tracking error and tracking difference?
Tracking error measures the variability of periodic return differences, while tracking difference measures the actual return gap between a fund and its benchmark over a specified period.
6. Is lower tracking error always better?
For funds tracking the same benchmark, lower tracking error generally indicates more consistent replication. However, investors should also examine tracking difference, expenses, liquidity, and fund structure before making comparisons.
7. What causes tracking error in index funds?
Common causes include fund expenses, transaction costs, cash holdings, changes in index constituents, corporate actions, liquidity limitations, and delays in adjusting portfolio holdings.
8. Is tracking error important when choosing an ETF?
Yes. Tracking error helps investors evaluate how consistently an ETF follows its benchmark. However, ETF investors should also examine expense ratios, bid-ask spreads, liquidity, and any premium or discount to NAV.
9. Where can I check the tracking error of Indian mutual funds?
Investors can check tracking error through mutual fund factsheets, asset management company websites, and AMFI’s tracking error and tracking difference facility.
10. Does low tracking error guarantee higher returns?
No. Low tracking error does not guarantee higher returns or protect investors from market losses. It only indicates greater consistency in following the benchmark during the measurement period.
Conclusion
Index tracking error measures how consistently an index fund or ETF follows its benchmark. It is calculated using the standard deviation of the differences between the fund’s periodic returns and the benchmark’s corresponding returns.
A lower tracking error generally indicates more consistent benchmark tracking, while a higher figure suggests greater variation in relative performance. Several factors can cause tracking error, including fund expenses, cash holdings, transaction costs, liquidity limitations, corporate actions, and changes in index constituents.
These factors make it difficult for a passive fund to replicate its benchmark perfectly at all times. Even well-managed index funds can experience some tracking error. Investors should examine tracking error alongside tracking difference, expense ratio, liquidity, benchmark composition, and the fund’s replication strategy.
Comparing funds that follow the same index over similar periods provides more useful information than relying on a single tracking error figure. Remember that low tracking error does not eliminate market risk or guarantee positive returns.
At ajay11.com, readers can explore more educational topics covering index funds, ETFs, passive investing, investment fees, portfolio diversification, and benchmark indices. Understanding these concepts can help beginners evaluate passive investment products and develop a more informed approach to long-term investing.
