What is Tracking Error in Nifty Index Funds?

Difference between Tracking Error and Tracking Difference in Index Funds and Exchange Traded Funds (ETFs).

As we all know, an index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Nifty 50 Index.

What Is Tracking Difference? 

How do you know whether the index fund or the ETF is tracking the index correctly?  In other words, we want to know whether the index fund is delivering the same returns of its benchmark index.

Index Fund returns are always compared with Total Returns Index of the benchmark index. In our case, Nifty 50 index fund has to be compared with Nifty 50 Total Returns Index.

Check the image below. Assume the Nifty 50 TRI went up 10% in 1 year, the Index fund has given 9.8% as its returns, the tracking difference is 0.2%

Tracking difference is the discrepancy between Index Fund/ ETF performance and index performance.

• The tracking difference is rarely nil, because there are many factors which prevent the fund from mimicking the index perfectly.
• Tracking difference can be small or large, positive or negative. 

Positive? Yes, there are few funds which give excess returns than index, in those cases the tracking difference would be positive.

What is Tracking Error?

Tracking error is the annualized standard deviation of daily return differences between the total return performance of the fund and the total return performance of its underlying index. 

In simple terms, tracking error basically looks at the volatility in the difference of performance between the fund and its index. 

Tracking Error is available from Monthly Fact sheet of the fund from the Mutual Fund websites.

What are the factors which cause high tracking error?

• Expense ratio - The lower the expense ratio, lower the tracking difference.
• Rebalancing costs - When NSE rebalances the index once in 6 months, some stocks removed and some added. The index funds/ETFs must adjust their holdings, to reflect the current state of the index. Buying and Selling involves transaction costs increasing the tracking difference.
• Cash Balance - Delay in deploying the cash received from investors may cause some tracking difference. Index components pay out dividends and deploying that cash may too cause some tracking difference.
• International funds or ETFs tracking difference could be because of currency variations and other related factors.

Summary:

Look for funds with low tracking error, because it is the best tool for assessing how the Index funds or ETFs perform with respective to their benchmark index.

If the fund or ETF has low tracking error, you might feel more confident that it will at least continue with roughly the same tracking difference it's delivered in recent history.  Lower the tracking error the better.