Tracking error is simply the difference between the performance of an index mutual fund and the performance of the index it tries to match. For example, if the index goes up by 5%, but the fund only goes up by 4%, there is a tracking error of 1%. A small tracking error means the fund is doing a good job of following the index.

Why Does Tracking Error Matter in Index Funds?

Tracking error is important because it shows how closely the fund follows the index. If you are investing in an index fund, you want it to follow the index as closely as possible. A high tracking error means the fund might not perform the way you expect, which could be disappointing for investors.

How Is Tracking Error Calculated?

Tracking error is calculated by measuring how much the returns of the fund differ from the returns of the index. It’s like checking if the fund’s performance is almost the same as the index or if there is a difference. A smaller tracking error means the fund is closely following the index.

What Causes Tracking Error in Index Funds?

Tracking error can happen because of a few reasons:

• Management Fees: High fees can cause the fund to underperform compared to the index.
• Cash Holdings: If the fund holds cash instead of stocks, it might not follow the index exactly.
• Dividends: Sometimes the way dividends are handled can affect the fund’s performance compared to the index.
• Different Stocks: If the fund doesn’t have all the stocks in the index, it may perform differently.

How to Minimize Tracking Error?

To reduce tracking error, look for index funds with low fees and those that hold all the stocks in the index. Also, choose funds that have shown good tracking error performance in the past. This will help the fund perform better and more like the index.