What Is Tracking Error? A Guide For Index Fund And ETF Investors

The domestic mutual fund industry has seen strong growth in the past few years. According to data from the Association of Mutual Funds in India (Amfi), the total assets under management (AUM) of the industry crossed Rs 87 lakh crore in August 2026. Notably, a portion of these funds is also flowing into passive instruments like index funds and exchange-traded funds (ETFs) as the category saw inflows of Rs 12,517 crore in August 2026.

As these types of passive funds mirror a market index or commodity rather than relying on a fund manager’s asset management skills, investors end up assuming that all index funds or ETFs tracking the same index or commodity are identical. However, that notion might not always be true as the ‘tracking error’ between two ETFs or two index funds can differ and ultimately impact your passive investment.

What Is Tracking Error?

Tracking error is a metric which measures how accurately a mutual fund or ETF mimics the performance of its underlying benchmark index or commodity. In purely mathematical terms, it is the standard deviation of the difference in daily returns between an index fund or ETF and its target index. However, the average mutual fund investor does not need to check the deviation themselves and can just check it using the website of the fundhouse where factsheets are uploaded for each scheme on a monthly basis.

Let’s understand this with an example, assuming the Nifty 50 index goes up by 15 per cent in a year, a perfect index fund would also go up by exactly 15 per cent. However, in reality, the fund might only return 14.80 percent. The volatility of this divergence over time is called the tracking error of the scheme.

On the other hand, there are many Nifty 50 ETFs available in the Indian market, while they all hold the exact same 50 stocks in the same proportion, their replication accuracy can vary. While some funds can have a tight three-year tracking error of around 0.04 percent, other schemes might have much higher tracking errors. Thus the low number in this case indicates strong replication which in turn means the investor is getting almost exactly what the benchmark index delivers, minus the minimal expense ratio.

What Causes Tracking Errors

It is important to understand what causes tracking errors in the first place. Typically, operational realities can cause a fund to deviate from its target index. Usually the daily deduction of management fees drags down returns compared to the cost-free theoretical index.

Another key cause of tracking errors is cash drag. Unlike an index, mutual funds must hold a certain amount of cash to take care of daily investor redemptions; thus they are rarely 100 per cent invested in the market at all times.

Apart from cash-drag the initiation of corporate actions such as dividend payouts can also cause temporary divergences because there is a delay between the time a company issues a dividend and when the fund manager reinvests that cash back into the portfolio. Transaction costs incurred by the fund house when the fund rebalances its holdings to reflect changes in the underlying index can also eat into a scheme’s performance and result in tracking error.

Why Tracking Error Is Critical For Passive Funds

For an actively-managed mutual fund scheme, the fund manager’s goal might be to beat the benchmark index. Thus, a high tracking error in an active fund is more common; it indicates the manager is taking independent bets and diverging from the index to generate excess returns, also known as alpha. However, for index funds and ETFs, the goal is different because the objective is the replication of the movement of the commodity or index funds. As these funds are built to deliver market returns, a high tracking error means the fund is failing at mimicking the returns of the underlying commodity or index.

How Tracking Error Helps Investors

When choosing an active fund, investors look at the manager’s track record, alpha, and portfolio strategy. However, when choosing an index fund or ETF, the tracking error becomes a key screening tool which can help investors in making more informed decisions. Thus, investors should ideally look for the lowest tracking error possible in ETFs and index funds.

Investors should understand even minor deviations from the index’s returns can potentially compound over time. Thus a small tracking error difference of just 0.05 per cent can also eat into an investor’s wealth over a 10- or 20-year investment horizon. Checking this metric ensures that individuals are actually getting the passive cost efficiency they were promised by the fund house.