Tracking error is a measure that shows how closely an index mutual fund follows its benchmark index, such as the Nifty 50 or Sensex. It helps investors understand how well the fund is replicating the performance of the index.

What Is Tracking Error in Index Mutual Funds?

Tracking error measures how closely an index mutual fund follows its benchmark index's performance. It is calculated by comparing the fund’s returns with the index returns over time. A lower tracking error indicates that the fund is closely matching the index, while a higher tracking error suggests that the fund's performance is deviating more from the index.

Why Does Tracking Error Matter?

Tracking error is important because it tells you how effectively an index fund mirrors its benchmark index. If you're investing in an index fund to replicate the performance of an index, a lower tracking error is desirable. It means that your fund is performing in line with the market and that you’re achieving the expected returns.

What Causes Tracking Error?

Several factors contribute to tracking error, including:

• Expense Ratios: High management fees can reduce the fund's ability to track the index accurately.
• Cash Holdings: If the fund holds cash, it might not perform exactly like the index, causing a tracking error.
• Rebalancing Delays: Funds may not always rebalance immediately after index changes, causing temporary mismatches.
• Sampling Techniques: Some funds use sampling rather than fully replicating the index, which can lead to discrepancies.
• Market Liquidity: Illiquid stocks may cause slippage and affect the fund’s performance relative to the index.

How to Evaluate Tracking Error?

To evaluate tracking error, compare it across different index funds. A fund with a lower tracking error is preferable, as it more closely follows the benchmark index. Additionally, check the fund's tracking error over time to see if it remains consistent. A sudden increase in tracking error could indicate issues with the fund’s management.

What Is the Regulatory Framework for Tracking Error in India?

In India, the Securities and Exchange Board of India (SEBI) regulates tracking error for equity exchange-traded funds (ETFs) and index funds. According to SEBI rules, the tracking error should not exceed 2% for these funds. This ensures that investors are protected and that the funds stay reasonably aligned with their benchmark indexes.

How Can You Minimize Tracking Error in Your Investments?

To minimize tracking error, consider the following tips:

• Choose Low-Cost Funds: Funds with lower expense ratios are more likely to track the index accurately.
• Check Fund Liquidity: Opt for funds that deal with liquid stocks to avoid slippage.
• Review Historical Tracking Error: Invest in funds with a history of low and stable tracking errors.