Investors have been turning to index funds to gain diversified market experience and achieve long-lasting financial goals. One main benefit of index funds is their relatively low fees than actively managed funds. However, index funds have unique risks and challenges, as with any type of investment. So, let’s explore tracking errors in Index Funds in detail.

What is a Tracking Error In Index Funds?

Tracking error is the annualized difference of standard deviation in returns between the Index fund and its benchmark Index. Tracking error measures how much an investment portfolio deviates from its benchmark index. It shows how well your investment is keeping up with the expected path. A higher tracking error indicates more deviation, which could mean higher risk or potentially higher returns. Investors use tracking errors to assess how closely their investments are according to the chosen benchmark and to evaluate the effectiveness of a portfolio manager in delivering the expected results.

How to Calculate a Tracking Error with Examples?

There are 2 ways to calculate the tracking error of index funds in India. The formula is: -

1. Tracking error= Return (P) - Return (i)

   Where P=Portofolio
   i=Index or benchmark

2. Tracking error= Standard Deviation of (P-B)

   Where P=Portfolio returns
   B=Benchmark returns

Example of tracking error of index funds in India

Tracking error measures how well an investment portfolio follows its benchmark index. To calculate it, subtract the benchmark's return from the portfolio's. For example, if the portfolio earns 8% and the benchmark earns 7%, the tracking error is 1%. It indicates how much the portfolio deviates from the benchmark.

What is a Good Tracking Error?

A good tracking error is typically low, indicating that fund closely follows its benchmark index. A lower tracking error indicates the fund performs closely to the chosen benchmark.

Investors generally prefer low tracking error, which signifies that the fund effectively replicates the index and minimizes deviations. However, what constitutes a "good" tracking error may vary based on individual investment goals, risk tolerance, and the specific strategy of the fund. Generally, the closer the tracking error is to zero, the better the fund tracks its benchmark.

Factors that Impact Tracking Error

• Management Fees and Expenses

  Index funds incur management fees and operational expenses. These costs affect the fund's returns, potentially causing tracking errors
  
  Also Read – Expense Ratio

• Income Distribution Cum Capital Withdrawal Reinvestment

  When a fund reinvests dividends, it may not precisely match the index's reinvestment process. Differences in timing or reinvestment rates can contribute to tracking errors. Tracking errors may arise if the fund's IDCW reinvestment strategy doesn't perfectly align with the index.

• Index Changes and Corporate Actions

  Index compositions change due to corporate events like mergers, acquisitions, or stock splits. Funds might not adjust immediately, causing tracking errors. Moreover, it can occur during periods of index rebalancing or corporate actions if the fund doesn't promptly reflect these changes.

• Liquidity and Trading Costs

  Differences in liquidity between the index's components and the fund's securities can lead to tracking errors. Like bid-ask spreads, trading costs impact the fund's ability to replicate the index

Advantages of Tracking Error

1. Performance Evaluation

   Tracking error is a metric to assess how well an investment fund is close to the benchmark. In addition, it quantitatively measures the fund's ability to replicate the index's returns.
   
   Investors can use tracking errors to gauge the effectiveness of portfolio management. A low tracking error indicates the fund follows the benchmark closely, demonstrating efficiency in tracking performance.

2. Risk Assessment

   Tracking error reflects the variability in returns between the fund and its benchmark. A higher tracking error implies higher level of risk as the fund's performance deviates more from the expected benchmark returns.
   
   Investors can use tracking errors to evaluate risk-related investments. A clear understanding of tracking errors helps manage expectations regarding potential deviations from the benchmark.

3. Cost Efficiency

   A Tracking error is sensitive to management fees and trading costs. Lower-cost funds tend to have lower tracking errors because fewer expenses must be covered through outperformance.
   
   It helps investors evaluate the cost efficiency of a fund. Investors can potentially achieve cost-effective exposure to market returns by choosing funds with lower tracking errors.

4. Benchmark Suitability

   Tracking error highlights how closely a fund aligns with its chosen benchmark. Some investors may prefer funds with minimal tracking error, while others may tolerate higher tracking errors for more potential returns .
   
   But the best part is it assists investors in selecting funds that perfectly align with their investment objectives and risk tolerance.

The Bottom Line

Tracking errors in index funds measures how closely the fund's performance aligns with its set benchmark. Usually, a lower tracking error is preferred, indicating that the fund closely tracks the expected index returns. Investors look for index funds with minimal tracking error to ensure their investment mirrors the chosen benchmark accurately.

However, the definition of a "good" tracking error is based on individual preferences and investment objectives. Understanding and monitoring tracking errors helps investors assess the fund's performance, manage risk, and make informed decisions aligned with their financial goals.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.