What is a tracking error?

Let’s assume that you have invested ₹1,00,000 in the Nifty 50 index fund. Now, let's say that the Nifty50 gained 10% in a year, while the Nifty 50 index fund rose by 9.0%. You may wonder why there is a difference in returns when the index fund is replicating the same index. The answer is tracking error. This is the difference in returns between the index fund and the benchmark index it is supposed to track.

In this article, we will explore tracking error, how it impacts investors, and how it can be calculated.

What is a tracking error in index funds? 

Tracking error is defined as the standard deviation of the difference between the returns of an index fund and its benchmark index. It is a measure of how closely an index fund tracks its benchmark. A lower tracking error indicates a closer correlation between the index fund's performance and its benchmark index. A higher tracking error, on the other hand, shows a weaker correlation between the two.

Tracking Difference of an Index Fund Over a 10 Year Period

Here’s a hypothetical example of the difference between the index returns and the fund's returns over 10 years. 

How to calculate tracking error? 

Now, let’s take a look at how to calculate tracking error. 

Tracking error is calculated as the standard deviation of the difference between the index's returns and the fund's returns. Here's how to calculate it:

1. First, calculate the index and fund returns for each period.
2. Then, calculate the difference between the index returns and the fund's returns for each time period.
3. Next, calculate the average difference.
4. Finally, calculate the standard deviation of the difference.

The formula for calculating tracking error is as follows:

Tracking error = Standard deviation (Fund returns - Index returns)

(Here, the standard deviation measures the deviation of a set of data from its mean. It is calculated by finding the square root of the sum of the squared deviations from the mean divided by the number of data points minus one.)

Let's take an example to understand how to calculate tracking error. Suppose an index fund has an average annual return of 12% over the past 5 years, while the benchmark index has an average yearly return of 12.5% over the same period. The standard deviation of the fund returns is 3%, while the standard deviation of the benchmark index returns is 2.5%. The tracking error of the fund can be calculated as follows:

Tracking Error = Standard deviation (Fund returns - Index returns) = Standard deviation (12% - 12.5%) = Standard deviation (-0.5%) = 0.5%

So, in this case, the tracking error of the fund is 0.5%.

Why does tracking error occur in index funds? 

Tracking error occurs in index funds due to several factors, such as differences in portfolio composition, expenses and fees, liquidity, and rebalancing.

1. Differences in portfolio composition: There might be a difference between composition of an index fund and benchmark index. This is because an index fund could be keeping some amount of money in cash in case of redemptions.
2. Expenses: Expenses and fees associated with an index fund can also contribute to tracking error. These expenses may include transaction costs like buying and selling stocks.
3. Liquidity: The lack of liquidity in particular stocks or securities can make it difficult for an index fund to replicate its benchmark index. This can also lead to tracking error.

Impact of tracking error on investors

Tracking error can significantly impact investors, as it affects the returns they receive on their investments. A higher tracking error means that the index fund's returns will deviate more from its benchmark index, potentially resulting in lower returns for investors. On the other hand, a lower tracking error can lead to higher returns for investors.

How to reduce tracking error in index funds 

Lowering expenses

• One effective strategy to minimise tracking error in index funds is minimising expenses.
• This can be achieved by selecting index funds with lower fees
• Lower fees will result in lower expenses, which can help to reduce tracking error.

Rebalancing at the right time and frequency

• Index funds should be rebalanced correctly by a fund manager when required to minimise tracking error.
• By monitoring the fund's performance and adjusting accordingly, rebalancing can be done at the optimal time and frequency.
• This can help to avoid high transaction costs and ensure that the fund stays closely aligned with its benchmark index.

Portfolio composition

• The index fund's portfolio composition can also impact tracking error.
• To minimise tracking error, index fund managers should ensure that the fund's portfolio closely matches the benchmark index's composition.
• This can be achieved by closely tracking the benchmark's changes and adjusting the portfolio to maintain consistency.