Index funds are becoming a preferred option for many investors on account of their low-cost structure, and patchy track record of active funds to consistently generate alpha.

While index funds mimic the portfolio of an underlying index, the returns generated by index funds deviate from that of the latter due to various reasons. Tracking error, which measures how well the fund generates returns vis-a-vis the target index’s returns, is one of the most important risk metrics in assessing the performance of index funds. Understanding how to read and compare the tracking error helps investors in choosing a better index fund.

What is it

Index funds, just like other MF schemes, incur expenses. These expenses are charged in the form of expense ratio to the investor and thus reduce the returns of the scheme compared to index. Besides, corporate actions, cash balance of the scheme and changes to the underlying index may also impact the scheme’s performance versus the benchmark.

The difference between the index product’s return from that of its benchmark index as on a particular date is called tracking difference. For example, the tracking difference of two index funds tracking Nifty 50 - HDFC Index Fund - Nifty 50 Plan and ICICI Pru Nifty Index Fund, as on September 30, 2021, for last one-year period is almost same at 1.06 percentage points.

Tracking error, which is usually confused with tracking difference, indicates the variability of the scheme’s performance over a certain period. It is calculated by annualising the standard deviation of the difference in returns between the index fund and its target index. Take the above example; despite both the funds having similar tracking difference as on September 30, 2021, the tracking error during the said period for HDFC is lower at 0.03 per cent compared to ICICI’s 0.06 per cent.

Lower the tracking error, lower is the divergence of returns of the fund to that of the target index during that period.

Asset Management Companies (AMCs) use various methods to bring down the tracking error. For example, when there is high cash balance with the fund, it would be temporarily invested in avenues such as fixed income securities, index futures contracts, etc., for a short period till reinvestment is made in the stocks.

Not comparable

Index funds aim to mimic the portfolio but practically cannot exactly mimic the returns. Indexing merely ensures that the returns of the fund will not stray far from the returns on the index. Lower tracking error indicates that the fund house has been efficient in managing the funds.

Thus, it is important to check and compare the tracking error of various funds before investing.

However, a look at the methodology of how the tracking error is being calculated by various AMCs reveals that an outright comparison is not doable.

For example, HDFC MF and ICICI Prudential MF calculate the tracking error based on daily rolling returns for the last 12 months. Nippon MF and SBI MF only consider three-year data, but the latter uses month-end NAV instead of daily.

Aditya Birla AMC reports the tracking error based on daily rolling returns for a three-year period, for those in existence for more than three years, else, it is calculated based on last twelve months data.

Some AMCs such as Motilal Oswal MF and DSP MF do not report tracking error for funds with less than 3 year NAV track record. Thus, the difference in methodologies makes the tracking error of index funds of various AMCs incomparable.

As a general rule, most funds try to keep the tracking error below two per cent.

Pratik Oswal, Head-Passive Funds, Motilal Oswal Asset Management Company, says “Since expense ratio is one of the significant components of the tracking error, investors can also look for funds whose costs are lower (not necessarily the lowest).”