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B. Venkatesh

YOU run tracking error risk when investing in index funds. What is this risk? Tracking error measures how the index fund has performed vis-à-vis its benchmark.

Suppose the Nifty index returns 4 per cent in a month, while the index fund benchmarked to the Nifty returns only 3.5 per cent, the fund is said to have a tracking error.

What if the fund generates 5 per cent returns instead? The fund still has a tracking error! The reason is that the fund has promised to perform only as well as the index.

That it has returned more than the index suggests the fund manager may have taken greater risk. And that is not good for the unit-holders.

How is tracking error calculated? First the difference between returns on the benchmark, say, the Nifty index and the index fund is computed.

The tracking error is the standard deviation of this difference. The tracking error is, therefore, the fluctuation in the differential returns between the index fund and its benchmark.

A low standard deviation means the fund has tracked the index well. You can also find whether the fund has consistently tracked the index well. How?

Suppose you have the daily differential returns between the fund and the Nifty for five years. Now take, say, the three-month rolling-period tracking error.

That is, you calculate the standard deviation of daily differential returns for month one to three, then from month two to four, and so on. Then, find the standard deviation for this rolling-period tracking error.

This essentially means a standard deviation of the standard deviation. A low standard deviation of the tracking error means the fund has been able to consistently track the index. If not, you are running a high tracking-error risk. Beware!

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