Tracking Error
Tracking error measures how consistently an index fund or ETF follows its benchmark index. It is the annualised standard deviation of the difference between the fund's daily returns and the index's daily returns.
What Is Tracking Error?
Tracking error tells you how closely a passive fund, such as an index fund or an exchange-traded fund (ETF), follows the index it is meant to copy. It measures the variability of the gap between the fund's returns and the index's returns.
SEBI's investor FAQs describe tracking error as the annualised standard deviation of the difference in daily returns between the underlying index and the NAV of the index fund. In simple words: if the fund's daily returns move almost in lockstep with the index, tracking error is low. If the fund sometimes runs ahead and sometimes falls behind by noticeable amounts, tracking error is high.
You will see tracking error in factsheets and on AMC websites for every index fund and ETF. It is one of the most useful numbers when choosing between passive funds that follow the same index.
How Does Tracking Error Work?
- Daily returns are measured. Each business day, the fund's NAV return and the benchmark index's (Total Return Index) return are calculated.
- The daily difference is noted. For example, if the index rises 1.00% and the fund rises 0.97%, the difference is −0.03 percentage points.
- Variability is calculated. The standard deviation of these daily differences over the past one year is computed. Standard deviation is a statistical measure of how widely numbers are spread around their average.
- The figure is annualised. The daily standard deviation is scaled up to an annual figure, typically by multiplying by the square root of the number of trading days in a year.
- It is disclosed regularly. SEBI requires all ETFs and index funds, including debt ones, to disclose tracking error based on past one-year rolling data. The figure is published daily on AMC websites and AMFI's website.
Why does a fund not match its index exactly?
- Expenses: The fund pays its expense ratio; the index has no costs.
- Cash holdings: The fund keeps some cash for redemptions, which does not move with the market.
- Timing of inflows and outflows: New money must be invested and redemptions met, causing small timing gaps.
- Index changes: When stocks enter or leave the index, the fund has to trade, often at slightly different prices.
- Dividends: Dividends received by the fund may take time to be reinvested.
- Liquidity and lot sizes: Some constituents, especially in debt or smaller-company indices, may be harder to buy in exact proportions.
Practical Example
Illustrative figures only.
Two index funds, Fund X and Fund Y, track the same equity index.
Step 1: Daily differences. Suppose over one year the standard deviation of Fund X's daily return differences is 0.02%, while for Fund Y it is 0.06%.
Step 2: Annualise. Assuming about 250 trading days, the multiplier is √250 ≈ 15.81.
- Fund X: 0.02% × 15.81 ≈ 0.32%
- Fund Y: 0.06% × 15.81 ≈ 0.95%
Step 3: Compare with tracking difference. Suppose over the same year the index TRI returned 12.00%, Fund X returned 11.70% and Fund Y returned 11.55%.
- Fund X tracking difference = 11.70% − 12.00% = −0.30%
- Fund Y tracking difference = 11.55% − 12.00% = −0.45%
Interpretation: Fund X followed the index more consistently (lower tracking error) and also lost less return to costs and frictions (smaller tracking difference). Between two otherwise similar funds, Fund X is the more efficient tracker.
Why Is It Important?
- It measures the quality of execution. All index funds on the same index hold similar stocks. Tracking error shows which fund manager replicates the index more precisely.
- It affects predictability. With low tracking error, you can expect your returns to closely mirror the index, which is the whole point of passive investing.
- It flags operational issues. A sudden rise in tracking error may point to large inflows, illiquid constituents or cash drag.
- It helps compare ETFs and index funds. Together with expense ratio and tracking difference, it is a key selection metric.
Key Features or Components
| Feature | Details |
|---|---|
| What it measures | Consistency of a fund's returns relative to its index |
| Calculation basis | Standard deviation of daily return differences, annualised |
| Data period | Past one-year rolling data (available data for newer funds) |
| Unit | Percentage per year |
| Ideal value | As close to zero as possible |
| Applies to | Index funds and ETFs mainly; also used for active funds in analytics |
| Disclosure | Daily on AMC and AMFI websites; also in factsheets |
Benefits and Limitations
Benefits
- Simple, standardised number for comparing passive funds on the same index.
- Regulatory limits and daily disclosure make it transparent.
- Highlights hidden frictions not visible in the expense ratio alone.
Limitations
- It does not show direction. A fund could consistently lag the index by 1% a year and still have low tracking error, because the gap is steady. That is why you also need tracking difference.
- It is backward-looking. One year of past data may not reflect future behaviour, especially after a change in fund size or index rules.
- New funds have limited data. Figures for funds with less than a year of history are based on available data and may be less reliable.
Comparison With Related Concepts
| Concept | Meaning | Key difference | Practical implication |
|---|---|---|---|
| Tracking Error | Annualised standard deviation of daily return differences | Measures consistency of tracking | Lower is better; shows reliability |
| Tracking Difference | Fund return minus index return over a period | Measures the size of the gap | Shows actual return lost to costs and frictions |
| Expense Ratio | Annual cost charged to the scheme | One cause of tracking difference | Lower cost generally means smaller tracking difference |
| Active Return (alpha in casual use) | Active fund's return over benchmark | Active funds aim for a gap; passive funds aim for none | For active funds, a gap is the goal, not a flaw |
How Does It Apply to Mutual Fund Investors?
- Choosing an index fund or ETF: Shortlist funds tracking the same index, then compare tracking error, tracking difference and expense ratio. Prefer funds that score well on all three over a longer period.
- Index Funds vs ETFs: ETFs also trade on the exchange, so you face an additional gap between market price and NAV. Low tracking error does not remove that price gap. See Index Funds vs ETFs.
- SIP investors: For long-term SIPs in index funds, small differences in tracking difference compound over many years, so even 0.2 percentage points a year matter.
- Monitoring: Check the factsheet occasionally. A tracking error that keeps rising is a reason to review your choice.
- Active funds: Analysts sometimes compute tracking error for active funds to see how far they deviate from their benchmark. Here a higher figure simply means the manager takes bigger active bets; it is not good or bad by itself.
Common Mistakes and Misconceptions
-
"Tracking error is the return I lose compared with the index."
- Correct view: That is tracking difference. Tracking error measures how variable the gap is.
- Why it matters: Looking only at tracking error may hide a fund that steadily lags due to high costs.
-
"Low expense ratio guarantees low tracking error."
- Correct view: Cash management, trading efficiency and fund size also matter.
- Why it matters: The cheapest fund is not always the best tracker.
-
"Zero tracking error is achievable."
- Correct view: Expenses and cash flows make some deviation unavoidable.
- Why it matters: Expect small numbers, but not zero.
-
"High tracking error means an active fund is bad."
- Correct view: For active funds, deviation from the benchmark is intentional.
- Why it matters: Judge active funds with risk-adjusted measures like the information ratio instead.
Important Terms to Know
- Benchmark Index: The market index a passive fund aims to replicate.
- Index Funds: Mutual funds that invest to mirror an index.
- Exchange-Traded Funds (ETFs): Index-tracking funds traded on stock exchanges.
- Expense Ratio: Annual fee charged by the scheme, a key driver of tracking difference.
- Active vs Passive Funds: The difference between trying to beat and trying to match an index.
- Volatility: Fluctuation in returns, measured by standard deviation.
- Risk-Adjusted Performance: Evaluating returns relative to risk taken.
Key Takeaways
- Tracking error measures how consistently a passive fund follows its index; lower is better.
- Always pair it with tracking difference, which shows how much return is actually lost.
- SEBI caps tracking error for equity ETFs and index funds at 2% (with limited exceptions) and requires daily disclosure.
- When comparing funds on the same index, look at tracking error, tracking difference and expense ratio together.
Related Glossary Terms
References
- SEBI: FAQs for Mutual Fund Investors (definition of tracking error)
- SEBI: Master Circular for Mutual Funds (20 March 2026) (tracking error and tracking difference limits and disclosure for ETFs and index funds)
Disclaimer
This content is for educational and informational purposes only and does not constitute personalised investment, tax or legal advice. All figures are illustrative. Mutual fund investments are subject to market risks; please read the scheme information documents and consider your goals and risk profile before investing.
Exploring passive investing? Continue with our guides on Index Funds and Benchmark Index at FynnChintan Finserv.
Frequently Asked Questions
What is a good tracking error for an index fund?
Lower is better. For large, liquid equity indices, many well-run funds report tracking errors well below SEBI's 2% ceiling. Compare funds on the same index rather than looking for an absolute number, because indices with less liquid constituents naturally have higher tracking errors.
Where can I find a fund's tracking error?
SEBI requires all ETFs and index funds to disclose tracking error based on one-year rolling data on a daily basis on the AMC's website and AMFI's website. Monthly factsheets also usually show the figure along with tracking difference over different periods.
Is tracking error the same as tracking difference?
No. Tracking difference is the simple gap between the fund's return and the index's return over a period, such as −0.4% in a year. Tracking error is the variability of daily gaps. A fund can have a steady gap (low tracking error) but still lose meaningful return (large tracking difference).
Why is tracking error higher for some indices?
Indices with smaller or less frequently traded stocks, or bonds that are hard to buy in exact proportions, are harder to replicate. Frequent index changes, large inflows relative to fund size and high cash requirements also raise tracking error.
Does tracking error apply to ETFs bought on the stock exchange?
The disclosed tracking error compares the ETF's NAV with its index. When you buy an ETF on the exchange, you pay the market price, which can differ from NAV. That premium or discount is a separate cost to watch, especially in thinly traded ETFs.
Can tracking error change over time?
Yes. It is calculated on rolling one-year data, so it changes daily. Market volatility, large inflows or outflows, index rebalancing and changes in fund size can all push it up or down.
This explanation is for general education only and is not investment advice. Mutual fund investments are subject to market risks; read all scheme-related documents carefully.