Tracking Error in Index Funds

Updated on 17 Oct, 2023

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Are you looking for a passive investment fund for your financial goals? Are you looking for returns that match the stock market? Then index funds can serve your purpose. This is a passive mutual fund that tracks and replicates the stock market index returns such as Nifty 50 or BSE Sensex. However, there is some difference in the returns between the index fund and benchmark index. This is the tracking error. In this article, we will discuss in detail about tracking error in index funds.

What is Tracking Difference?

Passive funds like index funds are those funds which replicate the benchmark index portfolio. Even though index funds try to mimic the benchmark returns, they do not match exactly. This is because mutual funds incur certain costs of buying and selling stocks and managing the portfolio. Thus, this difference in returns is the tracking difference. In simple words, tracking difference in index funds is the difference between the index fund return and the underlying benchmark index return.

To understand better, let us consider an example. Suppose the Nifty 50 index gained 6% this month. On the other hand, the NAV of index funds which track the Nifty 50 index gained 5.5% during the same period. This difference of -0.5%(5.5% – 6%) is the tracking difference of index funds.

A negative tracking difference indicates that the index fund has underperformed compared to the benchmark. However, the tracking difference is not always negative. A positive tracking difference indicates that the index fund has outperformed the benchmark.

What is Tracking Error in Index Funds?

Tracking error is the relative risk of the investment portfolio when compared to its benchmark. It helps to measure the performance of a particular fund. In other words, it measures the variability of performance of an index fund from its benchmark.

Tracking error indicates the consistency of a fund’s tracking difference during a specific period of time. Mathematically, tracking error is the standard deviation of the tracking difference of an index fund.

Tracking Error = Standard Deviation of (P – B)

Where,

P = Portfolio Returns

B = Benchmark Return

Example

Let us understand the tracking error with the help of an example. The following table shows the Nifty 50 returns, index fund returns and tracking difference over a period of five years.

Index Fund Returns (Portfolio)	Nifty 50 Returns (Benchmark)	Tracking Difference (P – B)
11%	12%	-1%
3%	5%	-2%
12%	13%	-1%
14%	9%	5%
8%	7%	1%

Tracking Error = Standard Deviation of ( 32/ (5-1))

Tracking Error = Standard Deviation of (8)

Tracking Error = 2.82

From the above table, we can infer the tracking error over five years is 2.8%.

Therefore, tracking error indicates how well the index fund tracks the benchmark index during the investment tenure. A low tracking error signifies that the portfolio closely follows its benchmark index. At the same time, a high tracking error signifies that the portfolio is not following the benchmark. Moreover, a tracking error in index funds cannot be zero because of expense ratio, fund cash flow and portfolio realignment due to changes in index composition.

Explore Fund Flow vs Cash Flow

Reasons for Tracking Error in Index Funds

The following are the reasons for tracking errors in index funds –

Mutual Fund Expenses

There are various expenses associated with mutual funds, like while buying and selling stocks, fund management charges, fund administration charges, etc. Usually, higher expenses lead to higher tracking error. To minimise the tracking error in index funds, the fund manager uses various strategies such as rebalancing the portfolio, managing dividend payments, lending securities, using Index futures or investing in fixed income instruments.

Maintaining Cash Balance

The fund manager of most mutual funds never invest 100% of their portfolio assets. They keep 2% to 5% of the total portfolio assets aside in cash or high liquid debt instruments. This helps them to address the redemptions.

Alternatively, an index mutual fund may incur a sudden inflow of cash due increase in investment or dividend payouts by stocks in the portfolio. In such cases, the fund manager may incur some time to invest this fresh inflow of money. Therefore, this can lead to an increase in tracking errors in index funds.

Difficulty in Buying/Selling

The tracking error in index funds also arises when the fund managers are unable to buy or sell the underlying index stocks. This could be due to low liquidity or sudden market movements, which increase the volatility of specific stocks. Generally, this situation is seen in sectoral or thematic funds. Also, these funds tend to have a high tracking error.

Importance of Tracking Error in Index Funds

The following pointers indicate the importance of tracking error in index funds –

Tracking error enable investors to compare the fund’s performance with its underlying benchmark index.
It helps to gauge the consistency of excessive returns and the fund’s risk level. To understand this, you must study the fund’s tracking error over a few quarters.
As an investor, you must check the tracking error rather than the fund returns. This helps to select funds with lower tracking error. Also, this will identify the minimum deviation of return from the benchmark index.
Tracking error also helps to determine how active and efficient the fund manager’s investment strategy is. It shows how well the portfolio is being managed.
By studying the tracking error, you can identify if the index fund is taking unnecessary risks by holding excessive cash levels in the portfolio or maintaining a one-sided index weightage.
If the index fund has a higher tracking error, it indicates a higher expense ratio. When the expense ratio is higher, the cost of managing the fund is more which reduces your portfolio returns over a period of time. Simply put, a high expense ratio can increase the index funds tracking error.

To conclude, while selecting index funds, choosing a fund whose tracking error is below the average of other index funds tracking the same benchmark is advisable. Also, this helps you to avoid selecting a fund with the lowest tracking error but gives a wide range of options to select a fund with lower than average tracking error. Therefore, while selecting funds, you must focus not only on returns but also select funds with low tracking error.