Tracking error
How much an index fund’s or ETF’s returns have deviated from its index over time; lower means it has followed the index more closely.
Tracking error measures how consistently a passive fund has followed its index. It is the standard deviation of the difference between the fund’s returns and the index’s returns, usually calculated from daily data and annualised. A fund that mirrored its index perfectly every day would have a tracking error of zero.
Why it matters
An index fund’s job is to deliver the index’s return minus costs, as predictably as possible. Tracking error shows how well it does that job. Among funds tracking the same index, it is one of the clearest quality signals, alongside the expense ratio.
How to read it
- Tracking error vs tracking difference. Tracking error measures how much the gap varies. Tracking difference measures the average gap — the fund’s return minus the index’s, which is usually negative because of costs. Both matter.
- Causes include expenses, cash held for redemptions, the timing of index changes, transaction costs and, for some indices, difficulty buying less-liquid constituents.
- Compare like with like. Funds tracking narrow or less-liquid indices tend to show higher tracking error.
Common misconceptions
- “Low tracking error means good returns.” It means close adherence to the index. If the index falls, a low-tracking-error fund falls with it.
- “Only the expense ratio matters for index funds.” Two funds with the same expense ratio can track their index with different precision.
In India: Index funds and ETFs disclose their tracking error, and fund houses publish the latest figures on their websites and factsheets.
Formula
Tracking error = Annualised standard deviation of (Fund return − Index return). Tracking difference = Fund return − Index return over a period
Worked example
For illustration, assume that over a year an index returns 12.0%, Fund A returns 11.7% (a tracking difference of −0.3 percentage points) and Fund B returns 11.4% (−0.6). If Fund A’s daily gaps were also more consistent, it would show a lower tracking error as well.
Figures are for illustration only — not a forecast or a recommendation.
Related terms
Index fund
A mutual fund that aims to replicate a market index by holding the index’s constituents in the same proportions, at low cost.
ETF
Exchange Traded Fund
A fund, usually tracking an index or holding gold or bonds, whose units are listed and traded on a stock exchange like shares.
Benchmark
The index a fund’s performance is measured against, chosen to represent the market or segment the fund invests in.
Expense ratio
The yearly cost of running a mutual fund scheme, shown as a percentage of its assets and deducted from the scheme before NAV is published.
Standard deviation
A measure of how widely an investment’s returns have varied around their average; a higher figure means a bumpier ride.