Tracking Error Versus Tracking Difference

Index funds and Exchange-traded funds (ETFs) have attained considerable popularity as investment tools in recent times. In this regard, tracking error and tracking difference can both be used to analyse funds. Also, since July 1, 2022, it is mandatory for all mutual fund companies to disclose the tracking difference, tracking error and iNAV (for ETFs)

While often the two terms are used interchangeably, however, there are certain key differences among them. 

Tracking error is the relative risk of the investment portfolio as compared to its benchmark index. It shows how often and how much the portfolio varies from the index. 

For an investor, tracking error is an indicator to gain insight on how well the fund is being managed as well as the risks involved. Tracking error is the difference between an investment portfolio’s returns and the index it mimics. It highlights the performance of portfolio managers. Tracking errors are also referred to as ‘active manager risk’.

There could be three main reasons for tracking error in index funds: expense ratio of mutual funds, cash balance and inability to buy or sell the underlying stocks. 

Tracking error helps to gauge a portfolio manager’s investment strategy as well as helps in comparing and measuring a portfolio’s performance with the respective index or benchmark. As per the Securities and Exchange Board of India (SEBI) guidelines, tracking error must be within 2% levels. 

On the other hand, tracking difference is a passive funds’ performance compared to its benchmark or indices over a certain time. In other words, it is the difference in returns over a certain period. As a fund’s total returns includes funds expenses, tracking difference is usually negative in the case of passive funds. However, tracking difference is rarely nil. Tracking difference is capped for debt ETFs and index funds to 1.25%.

A few of the causes of tracking difference include total expense ratio, rebalancing costs, corporate actions, unusual regulatory events and cash drags.

To sum it up, tracking error measures the variability rather than performance, while tracking difference measures the difference between an index fund’s returns and the benchmark index. 

These two remain important metrics for investors to check at least once year.

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