How tracking error affects your fund returns.

Today, we’ll cover tracking errors in Index Funds and explore how it can impact your returns.

The Story

Around 46% of young investors prefer index funds as per Motilal Oswal’s recent report. The total number of index funds surged to 207 in March 2024 from 44 in March 2021. The absolute growth is over 370%.

Though the concept of an index fund seems simple, the execution isn’t always easy. The performance of index funds can deviate from their benchmark even with minor discrepancies.

To evaluate this deviation, we use tracking error.

What is a tracking error?

Tracking error reflects the mismatch between the index fund returns and its benchmark returns.

An index fund is expected to provide similar returns as the benchmark but it deviates due to certain factors and tracking error proves to be the best way to measure how far the index fund has deviated from its benchmark.

It measures how closely a portfolio’s returns match its benchmark’s returns A well-managed index fund will have a lower tracking error.

What causes the Tracking Error?

There are two reasons why tracking error occurs in an index fund.

1. Cash Balance and Fund Expenses
Every mutual fund will have expenses to take care of that affect the returns of index funds. With these expenses, it becomes impossible for the fund manager to invest 100% of the fund. The fund houses also need cash to tackle sudden redemption requests. The benchmark index does not account for costs, while the fund’s actual performance reflects these deductions.

2. Adjustment Lag
The exact weight of the index keeps changing every single day. Index funds, on the other side, are not rebalanced daily. Even during buying or selling securities, the actual execution price may differ from the benchmark’s calculated value due to market volatility, especially in fast-moving markets.

Impact of tracking error on returns

A fund with low tracking error is preferable because it suggests that the fund manager is effectively mimicking the benchmark. Likewise, a higher tracking error may indicate inefficiency in fund management.

The above table shows that the Franklin India NSE Nifty 50 Index Fund with the highest tracking error of 0.11% has given a 12.96% annualized return.

The SBI Nifty Index Fund with the lowest tracking error of 0.02% has given 14.88% returns.

The highest return is offered by the TATA BSE Sensex Index Fund which has one of the lowest tracking errors of 0.06%.

To Conclude

The lower the tracking error, the higher the potential returns with lower risk, and vice versa

Investors should compare index funds based on their tracking errors to determine how well the fund is managed, reflecting the efficiency of the fund manager.