Tracking error in mutual funds
Tracking error is the standard deviation of the difference between a passive mutual fund’s returns and its benchmark index’s returns over a given period. The metric measures how closely a passive scheme replicates its underlying index: low tracking error indicates tight replication, high tracking error indicates significant deviation. For Indian passive investors, tracking error is the principal quality metric distinguishing well-managed from poorly-managed index funds and ETFs.
For passive investors choosing between competing NIFTY 50 index funds , NIFTY 500 index funds , or other index-tracking schemes, tracking error directly affects realised returns vs the index. Two index funds nominally tracking the same NIFTY 50 can deliver materially different returns over multi-year periods due to differing tracking errors.
Calculation
Formula
Tracking error (TE) is computed as:
TE = Standard Deviation (R_fund - R_index)
Where:
- R_fund = daily / monthly returns of the mutual fund.
- R_index = daily / monthly returns of the benchmark index.
- Differences computed period-by-period, then standard deviation taken.
Time period
Typically computed over:
- 1 year (12 monthly observations).
- 3 years (36 monthly observations), most common for stability.
- 5 years (60 monthly observations), long-term assessment.
Annualisation
Daily tracking error is annualised by multiplying by √252 (trading days per year). Monthly TE annualised by √12.
Tracking error vs tracking difference
These are related but distinct concepts:
| Metric | Measures | Significance |
|---|---|---|
| Tracking error | Volatility of difference (std deviation) | Replication consistency |
| Tracking difference | Average difference (mean) | Net return gap |
A fund may have low tracking error (consistent replication) but high tracking difference (consistently lagging by, say, 0.5% per year due to TER). Or vice versa.
Typical values for Indian passive funds
| Scheme type | Typical tracking error | Notes |
|---|---|---|
| Large-cap NIFTY 50 ETF | 0.05 to 0.15% | Tightest tracking; high liquidity |
| Large-cap NIFTY 50 index fund | 0.10 to 0.30% | Slightly higher than ETF |
| NIFTY Next 50 index fund | 0.15 to 0.40% | Mid-tier liquidity |
| NIFTY 500 index fund | 0.10 to 0.35% | Broad coverage; tighter than expected |
| NIFTY Midcap 150 index fund | 0.20 to 0.50% | Mid-cap rebalancing creates more drift |
| NIFTY Smallcap 250 index fund | 0.30 to 0.80% | Small-cap illiquidity creates more drift |
| Gold ETF | 0.10 to 0.30% | Physical-gold backing tightly tracks |
| International FoF | 0.50 to 1.50% | Currency, FoF wrapper, time-zone mismatch |
Lower tracking error is better, all else equal.
Causes of tracking error
Cash drag
- Mutual funds hold cash for redemptions and subscriptions.
- Cash earns money-market rate, not the index return.
- Higher cash holdings = higher tracking deviation from index.
Rebalancing costs
- Indices rebalance periodically (semi-annually for NIFTY).
- The fund must trade to mirror rebalancing.
- Bid-ask spreads, market impact, transaction costs create drag.
Constituent representation
- Some indices have hard-to-trade constituents (illiquid small-caps).
- Funds may sub-sample (hold a representative subset rather than all stocks).
- Sub-sampling increases tracking error.
TER drag
- TER directly reduces fund returns vs index returns.
- Adds to tracking difference (mean) but doesn’t directly affect tracking error (volatility).
Corporate actions
- Splits, bonuses, mergers create timing discrepancies.
- Index-effective-date may differ from fund’s execution date.
NAV-vs-close-of-trading timing
- NAV computed at end of day.
- Index also computed at close.
- For international funds: time-zone differences create drift.
Role in scheme selection
For passive investors:
- Compare tracking error across competing schemes tracking the same index.
- Lower TE = more reliable index replication.
- Combined with low TER (combined “all-in” cost), lower TE schemes deliver higher realised returns.
For ETF investors:
- ETFs typically have lower TE than index funds due to authorised-participant mechanism.
- But trading-side costs (bid-ask spread, premium/discount to NAV) offset some advantage.
Disclosure
Per revamped factsheet 2024 :
- Tracking error disclosed for passive schemes.
- Both 1-year and 3-year tracking error typically shown.
- Tracking difference also disclosed.
See also
- Mutual funds in India
- Index funds (India)
- Equity ETF (India)
- NIFTY 50 index fund
- NIFTY 500 index fund
- Total Expense Ratio (TER)
- Direct vs Regular TER
- AMFI standardised factsheet
- Revamped factsheet 2024
- Sharpe ratio
- Sortino ratio
- R-squared
- Std deviation MF
- Active vs passive equity India
- Index fund vs ETF
- TRI benchmarking
External references
References
- AMFI Best Practice Guidelines on passive-fund disclosure.
- SEBI master circular on factsheet disclosure.
- CFA Institute resources on tracking error methodology.