Tracking error in mutual funds is the difference between the returns of a mutual fund and the returns of its benchmark index. It impacts investors by showing how closely the fund is following the index. A low tracking error is better, as it means the fund is doing a good job of copying the index. A high tracking error may mean higher risks or poor fund management.

What Is Tracking Error in Mutual Funds?

Tracking error is the difference in returns between a mutual fund and its benchmark index. For example, if a Nifty 50 index fund is supposed to give the same return as the Nifty 50 index, but it gives slightly less or more, that difference is called tracking error. It is measured in percentage and tells how accurately the fund follows its index.

Why Does Tracking Error Matter to Investors?

Tracking error matters because it shows how well your investment is performing compared to the market. If you're investing in an index fund, your goal is to get similar returns as the index. A fund with low tracking error means you are getting the returns you expect. A high tracking error means your returns may vary a lot, which can affect your investment plan.

How Is Tracking Error Calculated?

Tracking error is calculated using the standard deviation of the difference in daily returns between the mutual fund and its benchmark index. In simple words, it checks how much the fund’s returns go up or down compared to the index. A smaller number means better tracking, and most index funds aim for tracking errors below 1%.

What Are the Main Causes of Tracking Error?

Some of the main causes of tracking error are fund expenses, cash holdings, delay in buying/selling stocks, dividend payouts, and changes in index composition. Sometimes, small differences in the timing of trades or market volatility can also cause small tracking errors. Expense ratio also plays a key role in affecting tracking accuracy.

How Does Tracking Error Impact Index Fund Performance?

Tracking error directly affects how well an index fund performs. If tracking error is low, the fund will give almost the same return as the index, which is ideal. If tracking error is high, it means you might not get the return you expected. This can impact your long-term investment goals, especially in passive investing where accuracy matters a lot.

How to Pick Mutual Funds with Low Tracking Error?

Before investing, check the fund's fact sheet or official AMC site. Look for a tracking error of less than 1% in index funds. Compare this across different funds tracking the same index. Also, check for low expense ratio and a consistent past performance. This will help you pick a reliable fund that gives stable returns.