What is tracking error in relation to index funds and ETFs?

Index funds and ETFs that is a passive mutual fund category invest the investor's corpus in securities of the underlying index in the proportion that the security helds in the targeted index. Not to forget the r proportion is realigned on a day to day basis as the weightage of the weightage changes. So, with the set investment in place, the fund manager primarily aims at providing the investor returns at par with the returns of the targeted index.

Nonetheless, at different times and instances and on account of several reasons, the returns from the investment in index fund or ETF does not match the return of the benchmark index. Such a discrepancy or deviation in return from the fund in comparison to what is offered by the targeted index is known as tracking error.

Calculation of the tracking error

The tracking error is computed against the Total Returns Index which is representative of the returns from the Index that includes the dividend.

Interpretation of the tracking error value

Tracking error i.e. the difference in return of the fund from the return provided by the targeted index can be high or low. Correspondingly, a high tracking error signifies a higher deviation in returns that the fund yields from the underlying index and vice-versa.

Reasons that result in tracking error

For the difference in the return different corporate actions, changes in the constituents of the index, cash levels held for liquidity purposes with the fund and the outflows and inflows are cited. Some of the other factors responsible for the deviation is the underlying securities breaching the lower or upper circuit.

Nonetheless, as the ETF fund does not sells or buys securities and the cash component also remains the same. And due to which their pay out to the stock broker is negligible and consequently in contrast the tracking error of the ETF fund in general is better over the other passive index fund. Know about ETFs here.

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