Tracking Error and Tracking Difference in Index Funds

An index fund is meant to deliver its index’s return, minus a small cost. Two numbers tell you how well it does that. Tracking difference is how much the fund’s return fell short of, or occasionally beat, the index over a period. Tracking error is how much that gap varied from day to day or month to month. The first tells you what the fund cost you; the second tells you how consistently it followed the index.

When choosing between index funds that track the same index, tracking difference usually matters more, because it is money, but a high tracking error is a sign that something in the fund’s operation is not working as it should.

Tracking difference: the shortfall

Suppose over a year an index returns 12.00% and an index fund tracking it returns 11.28%. The tracking difference is −0.72 percentage points.

That shortfall comes from several sources:

• The expense ratio, deducted from the fund daily. The index has no expenses.
• Cash held to meet redemptions, which does not earn the index return.
• Transaction costs when the fund buys and sells to follow index changes or handle flows.
• Timing differences between when the index changes its constituents and when the fund can trade.

Dividends received by the fund partly offset these costs, which is why the tracking difference is usually compared against the index’s total return version, the one that assumes dividends are reinvested. Comparing a fund with a price-only index flatters the fund.

Tracking error: the wobble

Tracking error is the standard deviation of the differences between the fund’s return and the index’s return over short periods, usually annualised.

Take twelve monthly gaps between the fund and its index, in percentage points: −0.05, −0.08, −0.02, −0.12, −0.04, −0.06, −0.03, −0.10, −0.05, −0.07, −0.01 and −0.09. They add up to −0.72, which matches the year’s tracking difference.

The standard deviation of those twelve monthly gaps is about 0.033 percentage points. Annualised by multiplying by the square root of twelve, the tracking error is about 0.12%.

Illustrative figures. Fund houses may compute tracking error from daily returns over a stated period; check the method and period in the factsheet.

A fund with a steady monthly shortfall has low tracking error, even if the shortfall itself is large. A fund that sometimes beats the index by a lot and sometimes lags by a lot has high tracking error, even if it averages out close to zero.

Why the two can point in different directions

Fund X follows the index very closely but costs you 0.70 points a year, most likely because its expense ratio is higher. Fund Y costs less but follows the index less precisely, perhaps because of larger cash holdings or less efficient trading.

For a long-term investor, Fund Y’s lower shortfall is worth more money. Fund Y’s higher tracking error is still worth a look: if it comes from occasional large deviations, those can go against you in a particular year.

How to use these numbers

1. Compare only funds tracking the same index, and the same plan type, because direct and regular plans have different costs.
2. Look at tracking difference over several periods, such as one, three and five years, not just one.
3. Use the total return index for comparison wherever it is available.
4. Treat unusually high tracking error as a question. Check the fund’s size, whether it has had large inflows or outflows, and whether the index itself is hard to replicate, such as one with many small, less liquid stocks.
5. Then check the expense ratio, which explains most of the tracking difference in well-run funds.

Where to find them

Index funds and exchange-traded funds typically report tracking error in their monthly factsheets, and many also publish tracking difference. Fund research websites often show both side by side for funds on the same index. You can also compute tracking difference yourself from the fund’s NAV history and the index’s published values over the same dates.

What these numbers do not tell you

They say nothing about whether the index itself is a good investment. A fund can track a narrow or expensive index perfectly and still be a poor fit for you. For ETFs, they also leave out a cost the fund does not control: the gap between the market price you pay on the exchange and the ETF’s underlying value, which depends on trading liquidity.

Past tracking figures are also only a guide to the future. A fund that has grown much larger, changed its fund manager, or started tracking a revised index may behave differently from its history. Check the numbers again each year rather than choosing once and never looking back, and switch only when the difference is persistent and large enough to outweigh any exit load and tax cost of moving.

Where this fits

• Choosing passive or active: active vs index fund · ETF vs mutual fund
• The cost behind most of the shortfall: what a 1% expense ratio costs
• Reading the rest of the factsheet: how to read a mutual fund factsheet
• Computing returns yourself: mutual fund returns calculator