Tracking Error vs Tracking Difference: How to Judge an Index Fund Beyond Returns

“Tracking difference” represents the gap between an index fund’s returns and those of its benchmark. In comparison, “tracking error” measures the volatility of this gap. It is calculated as the standard deviation of tracking differences.

An index mutual fund in India is a “passive” scheme that follows a particular stock market index instead of trying to select stocks that may perform better than the market. For example, 

• Suppose an index fund tracks the Nifty 50.
• Now, it will invest in the same 50 companies that form the Nifty 50. 
• The amount invested in each company is based on that company’s weight in the index.

Since the fund invests in the same securities and in similar proportions as the benchmark index it replicates, the potential returns could be identical to the index returns. However, the fund’s returns may not exactly match the index. 

As per general market understanding, this gap or “tracking difference” may arise due to several factors, such as:

• Variations in the execution of portfolio adjustments
• Fund expenses
• Transaction costs
• Cash holdings, and more.

Now, tracking error in index funds​ measures the consistency (or volatility) of this return gap over time. Want to understand better? Read this article to understand what tracking difference and tracking errors are, how they are calculated, how they differ, and the factors that can cause these deviations between a fund and its benchmark.

Tracking difference refers to the gap between the returns generated by an index fund and the returns of its benchmark index. Now, tracking errors in index funds​ measure the “volatility” of this gap by calculating the standard deviation.

As per general industry understanding, a fund with a lower tracking error may have comparatively smaller fluctuations in this return difference as compared to a fund with a higher tracking error (also indicates greater deviation). 

Tracking error is calculated as the “standard deviation” of the tracking difference. 

Mathematically, the tracking error formula can be represented as follows:

Where,

For more clarity, let’s study an example:

Example

Suppose an index fund and its benchmark generate these monthly returns:

The tracking differences are -0.2%, +0.1%, -0.2% and -0.3%. Now, the standard deviation of these tracking differences represents the tracking errors in index funds​.

Both tracking difference and tracking error compare an index fund's performance with that of its benchmark index. But if we talk about the primary difference between them:

• Tracking difference shows the size and direction of the return gap.
• Whereas a tracking error indicates how much that gap fluctuates (volatility).

For more clarity, let’s check out a detailed comparison:

An index mutual fund in India is designed to track/ replicate the performance of its benchmark index. However, the fund's return can differ from the index return because the fund incurs transaction costs, holds cash at times, and may not replicate every index change at the exact same time. 

Let’s understand these factors in detail:

1. Fund Expenses

An index fund incurs several operating expenses to manage and run the scheme. These costs are deducted from the scheme’s assets and expressed in the form of an “expense ratio”. For example, 

• Suppose an index fund has an expense ratio of 0.20%.
• This shows that the fund's annual expenses are equivalent to 0.20% of its assets. 

Since the replicated index does not have these fund-level expenses, the fund's return can be lower than the index return.

2. Transaction Costs

An index does not buy or sell securities. But an index mutual fund replicating it must conduct transactions when it:

• Builds its portfolio
• Receives investments
• Processes redemptions, or 
• Adjusts its holdings after an index change

These transactions may involve brokerage, bid-ask spreads, and other trading-related costs. Such costs are borne by the index fund and can influence its NAV.

3. Portfolio Rebalancing

A market index does not remain static. Its constituents and their weights can change when the index is reviewed and rebalanced. The index mutual fund must then adjust its portfolio to reflect these changes. 

Now, while making such portfolio adjustments, the fund may not be able to buy or sell every security:

• At exactly the same price 

or

• At exactly the same time as the index's theoretical rebalancing. 

These differences in execution can influence the fund's return and contribute to a variation between the index performance and the fund's performance.

4. Cash Holdings

An index fund may hold a percentage of its total assets in the form of cash and cash-equivalent assets to meet:

• Investor redemptions
• Manage expenses, or 
• Handle other fund requirements

In comparison, the benchmark index represents the performance of its underlying securities (according to its methodology) and does not maintain a comparable cash balance. 

When the market potentially rises, money held outside the securities in the index does not participate in that rise to the same extent. This leads to tracking error in index funds​ and can cause the fund's return to differ from the index. The impact may vary depending on the amount of cash held and market conditions.

5. Corporate Actions and Dividend Treatment

Companies followed by a benchmark index may announce:

• Dividends
• Bonus shares
• Rights issues
• Stock splits, or
• Other corporate actions

Now, an index fund must account for these events within its portfolio, but the timing and treatment of these corporate actions can lead to tracking errors in a mutual fund​. These differences can again cause the fund's performance to vary from that of its benchmark index. 

When evaluating an index fund, looking only at its past returns may not be the “right” approach. Since the fund's objective is to replicate a benchmark index, investors may check how closely it has followed that index. 

This includes looking at its tracking difference and tracking error. Besides, investors can also consider:

• Expense Ratio: An index mutual fund with a lower expense ratio may be preferred as it may potentially reduce the cost charged to the scheme’s assets.
• Portfolio Composition: An inspection of the portfolio holdings may be performed to check how closely the scheme's investments correspond to its benchmark. 

So now you know what tracking differences and tracking errors in index funds are and how they differ. To revise, tracking difference is the gap between an index fund’s returns and those of its benchmark. 

In contrast, tracking error is the standard deviation of these return differences and shows how much the gap fluctuates over time. As per general market understanding, a lower tracking error indicates that the fund’s performance has remained more consistent relative to its benchmark. 

Usually, a scheme with a lower tracking error and a smaller tracking difference may potentially be preferred, as this suggests that its returns may have remained closer to the benchmark with less variation in the gap.

For more information, you can visit www.tatamutualfund.com/deshkarenivesh. The Investor Service Centre of Tata Asset Management Pvt. Ltd. is located at Mulla House, Ground Floor, 51, M.G. Road, Near Flora Fountain, Mumbai – 400 001, Maharashtra. The office hours are Monday to Friday, 9:00 AM to 5:30 PM. For assistance, you can also call (022) 6282 7777 from Monday to Saturday, 9:00 AM to 5:30 PM, or email service@tataamc.com

1. What is tracking error in index funds, and how is it calculated?

A “tracking difference” is a measure of the gap between an index fund’s returns and its benchmark returns. Now, “tracking error” measures the volatility of these deviations. 

It is calculated as the standard deviation of the fund’s tracking differences determined across multiple periods.

2. Can a low tracking error guarantee that an index fund will deliver higher returns?

No, a low tracking error may potentially indicate that the fund’s returns have shown less variation from its benchmark. It does not mean the fund will generate higher returns in the future.

3. Why can an index fund’s returns differ from its benchmark?

An index fund may not exactly match its benchmark because of several factors, such as:

• Operating Expenses reduced from the scheme’s assets
• Transaction costs
• Cash holdings
• Portfolio rebalancing, and
• The timing of trades

These factors can create a difference between the fund’s returns and the index returns. The size of this gap is reflected in the fund’s tracking difference.

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