How to Analyse Tracking Error When Choosing Index Mutual Funds in India
When choosing index mutual funds in India, the objective is simple: achieve returns that closely mirror the performance of the benchmark index. However, not all index funds track their benchmarks equally well. At AMS Investments, understanding tracking error in index funds can help investors evaluate how efficiently a fund follows its benchmark. Knowing how to interpret this metric is an important step when comparing index mutual funds and making informed investment decisions.
What Is Tracking Error in Index Funds?
Tracking error measures how consistently a fund follows its benchmark. Technically, it is the standard deviation of the difference between the fund's daily or periodic returns and the index's returns over a given period.
A low tracking error means the fund is closely replicating the index, while a high tracking error indicates that the fund's returns deviate more significantly from its benchmark. For passive investors, understanding this difference is important when evaluating the efficiency and consistency of an index fund. AMS Investments helps investors understand such key factors when comparing index mutual funds and making informed investment decisions.
Tracking Error vs Tracking Difference
Before going further, it is worth distinguishing two related but separate concepts:
Tracking Difference is the total return gap between the fund and the index over a period. It shows how much the fund underperformed or outperformed the index cumulatively.
Tracking Error in Index Funds is the volatility of that gap over time. It indicates how consistently the fund followed its benchmark.
Both metrics are important, but tracking error is particularly useful for assessing the reliability and consistency of a fund's performance.
Why Tracking Error Matters When You Choose Index Mutual Funds in India
India's passive fund landscape has grown considerably, with funds tracking a wide range of indices, including large cap, mid cap, sectoral, and factor based indices. Since multiple funds may track the same index, tracking error becomes an important factor when evaluating how to choose index mutual funds in India.
Even a small, persistent deviation can affect returns over a long investment horizon. If two funds track the same index but one consistently demonstrates a lower tracking error, it may be the more efficient choice for a passive investor, assuming other factors are comparable.
Key Factors That Cause Tracking Error
Understanding what drives tracking error can help investors evaluate the quality and efficiency of an index fund:
Expense Ratio: Higher fund expenses can widen the gap between fund and index returns.
Cash Drag: Funds may hold a portion of their assets in cash to meet redemptions. Cash can generate lower returns than equities during a rising market.
Rebalancing Lag: When an index changes its constituents, the fund needs to replicate those changes. Delays in execution can create temporary deviations.
Dividend Reinvestment Timing: An index's Total Return Index generally reflects dividend reinvestment, while the actual fund may take some time to reinvest dividends received from portfolio companies.
Securities Lending Income: Some funds may generate additional income through securities lending, which can partially offset tracking differences.
How to Check Tracking Error of Index Funds: A Step-by-Step Approach
Knowing how to check tracking error of index funds is a practical skill for investors considering passive investment options. Here is a structured approach:
Source the NAV Data: Download the fund's daily Net Asset Values from the fund house's website or AMFI's official data portal, preferably covering a meaningful period such as one to three years.
Source the Index Data: Obtain the corresponding Total Return Index (TRI) values for the same period. TRI is preferable to a price index because it accounts for dividends.
Calculate Daily Return Differences: Calculate the daily percentage return of the fund and the corresponding TRI return, then determine the difference for each period.
Compute Standard Deviation: Calculate the standard deviation of the series of return differences. If required, annualise the result using the appropriate trading day convention.
Interpret the Result: A lower tracking error generally indicates more consistent benchmark replication. Investors should compare the figure with similar funds tracking the same index rather than relying on a single threshold.
At AMS Investments, understanding tracking error alongside factors such as expense ratio, tracking difference, fund size, and portfolio replication can help investors make a more informed comparison when selecting index mutual funds in India.
Comparing Tracking Error Across Funds
Once you know how to check tracking error of index funds individually, the real insight comes from comparison. The table below illustrates a hypothetical framework for comparing funds tracking the same index use this structure when you conduct your own analysis:
Evaluation Criterion | What to Look For | Why It Matters |
Annualised Tracking Error | Lower is better; aim for below 0.5% | Indicates reliability in replicating the index |
Tracking Difference (1-Year) | Negative or near-zero preferred | Shows cumulative return gap relative to benchmark |
Expense Ratio | Direct plans offer lower costs | Lower expenses reduce the structural return drag |
AUM Size | Larger AUM generally aids liquidity | Easier rebalancing with lower market impact cost |
Consistency Over Time | Stable tracking error across market cycles | Demonstrates operational discipline of the fund house |
Using Price Index Instead of TRI: Comparing fund returns against a price index can make the fund's apparent underperformance look larger because dividends are excluded from the price index. Using the Total Return Index provides a more appropriate comparison.
Looking at Too Short a Period: A single quarter of data may not provide enough information. Market conditions change, so tracking error should ideally be assessed over a longer period and across different market conditions.
Ignoring Consistency: A fund may show a low average tracking error, but significant spikes during volatile periods can indicate inconsistency in benchmark replication.
Selecting Solely on Tracking Error: While tracking error is an important factor in how to choose index mutual funds in India, it should be considered alongside expense ratio, tracking difference, AUM, liquidity, and the fund house's passive fund management approach.
For investors evaluating index mutual funds, AMS Investments recommends looking at tracking performance as part of a broader fund evaluation rather than relying on a single metric.
Putting It All Together
Analysing tracking error in index funds is not a one time exercise. Markets evolve, fund strategies and operational processes can change, and indices are periodically reconstituted. Reviewing tracking error at least once a year can help ensure that your chosen fund continues to replicate its benchmark efficiently.
For investors in index mutual funds in India, regularly monitoring tracking error can help distinguish informed passive investing from simply selecting an index fund without evaluating its performance. A lower and more consistent tracking error can be an important indicator of efficient benchmark replication when considered alongside factors such as expense ratio, tracking difference, liquidity, and fund size.
Not sure whether your index fund is tracking its benchmark efficiently? Get a structured review of your current holdings and understand what the numbers really mean. Connect with the AMS Investments team today for personalised insights and informed index fund selection.
