Tracking error
Also written Tracking difference
The gap between the return of a passive fund and the return of the index it is trying to replicate — the measure of how faithfully an index fund or ETF does its one job.
In plain language
An active fund promises to beat its benchmark. A passive fund promises only to be it — to hold every stock in the index, in the index's own weights, and to deliver whatever the index delivers.
A fund can fail at that. Not by much, but it can. The difference between what the passive fund returned and what the index returned is the tracking error, and the workbook's standard is unambiguous: it "ideally should be as close to zero as possible."
For a passive fund, tracking error is the only performance number that matters. Asking whether an index fund beat the Nifty is the wrong question. Asking how closely it kept up is the right one.
How it works
A passive fund replicates by construction: it buys all the constituents of the index in the same proportion as their index weights, sells any stock removed from the index, and buys whatever replaces it. No research team, no stock selection — which is why management fees on passive funds are lower than those of active funds.
The gap nonetheless opens up from four ordinary frictions:
- Expenses. The index is a calculation and costs nothing to run. The fund has a Total Expense Ratio, and it is deducted from the fund's NAV every single day. This is usually the largest single component.
- Cash drag. Money arriving from new investors is not invested the instant it lands, and a small cash buffer must be kept for redemptions. Cash does not earn the index return.
- Rebalancing cost. When the index committee swaps a constituent, the fund must sell one stock and buy another, paying brokerage, impact cost and taxes to do it.
- Dividend timing. The index assumes dividends are reinvested at a point in time; the fund actually receives the cash later and deploys it later.
The structure of the fund matters for the investor too. Index funds are bought and sold like any mutual fund, at the NAV determined by the applicable cut-off timing. ETFs trade on the exchange like stocks, at whatever price the market is quoting at that moment, so an ETF buyer faces a second gap — the difference between the traded price and the underlying value — on top of the fund's own tracking error.
A worked example
A Nifty 50 index fund with a Total Expense Ratio of 0.20 per cent a year.
Over the financial year the Nifty 50 Total Return Index gains 14.00 per cent. The fund's NAV rises 13.72 per cent.
Tracking error = 14.00% − 13.72% = 0.28% = 28 basis points
Where did the 28 basis points go?
| Source | Basis points |
|---|---|
| Total Expense Ratio | 20 |
| Cash held for redemptions and un-deployed inflows | 5 |
| Index rebalancing — brokerage, impact cost, taxes | 3 |
| Total gap | 28 |
On a holding of Rs 10,00,000, that is the difference between Rs 11,40,000 and Rs 11,37,200 — Rs 2,800 for the year.
Small, and worth putting beside the alternative. An actively managed large-cap fund charging 1.80 per cent starts each year 180 basis points behind the same index and has to out-select the market by that much merely to draw level. The workbook notes that in developed markets such as the United States, actively managed funds find it difficult to beat the returns of their benchmark — which is the argument for paying 28 basis points of tracking error instead.
Why NISM asks about it
Chapter 5, section 5.5 (Investment approaches — active and passive), where 5.5.2 introduces passive investing and names the gap: "The returns of the passive fund can differ marginally from that of its benchmark. This difference is known as the 'tracking error' and ideally should be as close to zero as possible." Expect a definitional question, a question on which fund type tracking error is relevant to (passive, not active), and comparison questions on active versus passive — higher fees and in-depth research on one side, lower fees and replication on the other. SEBI's May 2022 guidelines on the development of passive funds sit in the same section.
Common exam traps
- Tracking error applies to passive funds, not active ones. An active fund is trying to differ from its benchmark; calling that difference tracking error misses the point of the section entirely.
- Lower is better, always. Unlike alpha, there is no good direction. A passive fund that beat the index by 40 basis points has tracked it just as badly as one that lagged by 40.
- Tracking error is not the expense ratio, even though the expense ratio is usually the biggest cause of it. TER is an input; tracking error is the outcome.
- Strictly, statisticians call the plain return gap the tracking difference and reserve tracking error for the standard deviation of that gap. NISM defines it as the difference. Answer the workbook.
- An ETF's market price is not its NAV. ETF units trade at whatever the exchange quotes, which can sit above or below the underlying value. That premium or discount is separate from the fund's tracking error.
- Index funds and ETFs are both passive, but transact differently — index funds at the applicable cut-off NAV, ETFs at live traded prices, where an investor can place limit orders.
Where this is taught
- Series V-B · Chapter 7: Performance of Mutual Fundsintroduced here
- Series V-D · Chapter 11: Mutual Fund Scheme Performanceintroduced here
- Series VIII · Chapter 2: Understanding Indexintroduced here
- Series V-A · Chapter 11: Mutual Fund Scheme Performanceintroduced here
- Series XII · Chapter 5: Mutual Fundsintroduced here
- Series X-A · Chapter 16: Portfolio Performance Measurement and Evaluationintroduced here
Related terms
- Net Asset ValueThe net assets of a mutual fund scheme divided by the number of units outstanding — what one unit of the scheme is worth on a given day, after every liability except the unitholders' own.
- Total Expense RatioThe all-in annual cost of a mutual fund scheme as a percentage of daily net assets — the base expense ratio plus brokerage, transaction cost and statutory levies — charged to the scheme, not billed to the investor.
- Unit capitalThe number of units a mutual fund scheme has issued multiplied by their face value — an accounting figure that records what investors contributed, not what their holding is worth today.
- Indicative NAVThe per unit NAV of an ETF based on the current market value of its portfolio during trading hours, disclosed continuously on the stock exchanges.
- Treynor ratioRisk premium per unit of market risk — the return a scheme earned above the risk-free rate, divided by its beta rather than by its standard deviation.
- Exchange Traded FundA mutual fund scheme whose units are listed and traded on a stock exchange like a share, so you transact at live prices through the day instead of at one end-of-day NAV.
- BenchmarkThe independently published index a scheme's performance is measured against, chosen to match its investment objective, asset allocation and strategy, and disclosed in the Scheme Information Document.
- Total Return IndexThe variant of a market index that adds the dividends and interest paid by its constituents to their price movement — the only variant a mutual fund scheme may be benchmarked against since 1 February 2018.