What is Tracking Error in Index Funds and Its Impact on Index Fund Returns

Tracking error is a key term closely associated with the performance of an index fund. Tracking error can be defined as the variation in the performance of an index fund versus the performance of its underlying index. While tracking error is commonly considered with respect to index funds, the concept is also applicable to other passively managed schemes such as Exchange Traded Funds (ETFs) and Fund of Funds that invest in ETFs.

Tracking error is an effective method for comparing investment performance against its given benchmark. It demonstrates how closely a passively managed investment has replicated the performance of its chosen benchmark. The smaller the tracking error of a passive investment, the more closely it replicates the performance of the index being tracked.

There are two ways in which you can calculate a tracking error. Below are illustrations of both ways for easier understanding.

An Index Fund with a low tracking error indicates that its performance closely mirrors its benchmark. A fund with a high tracking error, on the other hand, denotes significant deviation from the performance of its underlying index. This can lead to higher risk and volatility for investors.

It should be noted that tracking error can never be zero due to the involvement of several factors, such as the expense ratio, the cash flow of the funds, and changes to the portfolio because of changes in the underlying index's composition. This is one of the most important points to remember when it comes to index funds.

There are primarily three reasons for tracking error to occur in index funds. They have been discussed below:

Here are some of the other factors that influence tracking error:

• Portfolio size
• Variations in market capitalization, investment approach, timing, and other portfolio features
• Alterations in index constituents
• Corporate activities
• Market instability
• Management fees, brokerage expenses, custodial charges, and other costs impacting the investment portfolio but not the benchmark
• Portfolio's beta coefficient

Tracking error is a useful metric for comparing and contrasting a fund's performance relative to its benchmark, which includes both underperformance and outperformance.

When there is a degree of outperformance, investors often anticipate a bigger tracking error. On the other hand, when there is consistent underperformance, a reduced tracking error is evident. However, it is vital to highlight that tracking error alone does not distinguish between these two circumstances.

It would be wise for an investor to understand tracking error and its impact and utilise this metric as an indicator of how actively a fund is managed and its subsequent risk level. One useful method for selecting index funds is to priorities funds with lesser tracking errors than the average of all other funds using the same benchmark.