Two friends met over coffee and were discussing passive investment products such as index funds and ETFs.

Arpit: Hey! Markets have corrected in recent times which gives me an opportunity to buy at lower levels. So, I want to invest ₹1 lakh in an index fund which would track Nifty 50. Going through fund scheme documents, I came across a line “returns that are commensurate with the performance of NIFTY 50 Index, subject to tracking error”. So, what is this tracking error?

Aakash: Your question comes at the right moment. Recently, regulator SEBI came up with a circular on passive funds, which also mentioned tracking error norms. To understand tracking error, we need to look at tracking difference first.

Arpit: Okay. What is tracking difference?

Aakash: Tracking difference measures the extent to which the performance of an index fund/ETF differs from that of the index (for example, Nifty 50). This benchmark is what is being tracked for a particular duration, say one year. For instance, if Nifty has fallen by 10 per cent in six months and an index fund has fallen 12 per cent, then tracking difference is negative 2 per cent or 200 basis points. 

Arpit: So, if tracking difference is 2 per cent, is tracking error also close to 2 per cent?

Aakash: No. Tracking error shows the annualised volatility of tracking difference rolled for a period — say, on a daily basis.

Arpit: Okay. You mean to say, tracking difference reflects the difference in performance, while tracking error captures the variability of that difference over time. Right?

Aakash: Yes, exactly.

Arpit: Why does tracking error occur?

Know the terms
Tracking difference reflects the difference in performance, while tracking error captures the variability of that difference over time

Aakash: There are multiple reasons for that. One, for unforeseen investor redemptions, mutual funds need to hold certain portion, say, 5 per cent, of the corpus in cash. This can have an impact.

Two, sometimes, stocks are reshuffled within the index. For instance, in March 2022, IOC was dropped from the Nifty 50 index, while Apollo Hospitals was added. It will take the index fund manager time to replicate the actions at the fund level, which can lead to tracking error.

Also, tracking error can happen due to management expenses and the firm’s inability to buy/sell stocks in case of sudden market movements or low liquidity.

Arpit: Understood. So, can tracking error be eliminated?

Aakash: Not completely, but it can be minimised. For instance, you have a property in Chennai, which you won’t be using in the near future. So, what will you do with that?

Arpit: Obviously, I will rent it out to someone and earn rental income.

Aakash: Exactly. It works here too. Many a time, there are a few stocks which would not require selling on an urgent basis; they are lent by fund managers, thereby earning lending fees. These lending fees can be added to the passive fund income which can offset the lost returns due to reasons mentioned earlier. Also, there are other complex ways to minimise tracking errors such as using index futures, temporary investment in money market instruments using cash. It depends on the fund manager’s efficiency in managing tracking error.

Arpit: Okay. So, while comparing ETFs/index funds, one should look at tracking error.

Aakash: Yes, but it’s not that easily comparable due to inconsistencies involved in reporting. Fund houses become selective in reporting tracking error. For instance, Index Fund A would report tracking error considering daily rolled returns for the last one year. Index fund B will report the same based on the last three years. There are even cases when certain schemes won’t be aged enough to put up a number. Hence, different methodologies in reporting tracking error make it difficult to compare funds on a like-to-like basis.

Arpit: Is SEBI looking into this?

Aakash: Yes, in the latest circular SEBI has come up with a standard tracking error reporting process. Effective July 1, ETFs/Index funds need to disclose past one-year tracking error rolled on a daily basis on the website of AMFI and the respective fund houses. Also, there is a cap of 2 per cent placed on tracking error for equity ETFs/Index funds.

Along with tracking error, SEBI has mandated fund houses to disclose tracking difference on a monthly basis for one, three, five and ten years. Here too, there remains a cap of 1.25 per cent for debt index funds/ETFs, the level which the annualised tracking difference can’t exceed.

Arpit: But what if the fund was launched less than a year ago?

Aakash: In that case, annualised tracking error would be based on available data.

Arpit: Thanks a lot for this knowledge. Now, let me pay your coffee bill.