What Is Tracking Error and Why It Matters in Mutual Funds?

Most investors focus on returns when evaluating a mutual fund. However, returns alone may not always explain how closely a fund is performing relative to the market or benchmark it aims to follow. In certain types of mutual funds, particularly those that seek to replicate an index, like index funds, small differences between the fund’s performance and the benchmark may arise over time.

Understanding these differences can help investors interpret fund performance more realistically and avoid forming expectations that may not align with how the scheme is designed to operate. This is where an important concept related to fund performance measurement becomes relevant.

What Is Tracking Error?

Tracking error refers to the difference between a mutual fund’s returns (actual performance) and the returns of its benchmark (benchmark index it aims to replicate), measured over time. It shows how closely the fund moves in line with the benchmark it is linked to.

When a fund follows or compares itself to an index, its returns may not match the benchmark exactly in every period. Tracking error captures the pattern and extent of these differences across multiple periods, rather than focusing on a single return gap.

What Do High and Low Tracking Errors Indicate?

High and low tracking errors are descriptive signals, not verdicts. They help interpret how a fund behaves in relation to its benchmark over time.

A low tracking error indicates that the fund’s returns stay close to the benchmark most of the time. This suggests a higher level of consistency in how the mutual fund follows its stated reference. For funds designed to track an index (passive funds), this reflects closer alignment with the mandate.

A high tracking error indicates that the fund’s returns move away from the benchmark more often or by larger margins. 

The deviation can occur in either direction and does not, by itself, imply better or worse returns.

What matters is context. Tracking error needs to be read alongside the fund’s objective and structure. On its own, it only explains the degree of deviation, not the reason behind it or the quality of outcomes.

Why Does Tracking Error Occur?

Tracking error occurs because mutual funds operate in real market conditions, while benchmarks are only reference points. An index does not face costs or operational constraints. A fund does.

• Expense ratio: Fund expenses reduce returns, while benchmark returns are shown without costs. Over time, this creates a difference.
• Cash management: Funds receive inflows and face redemptions. Not all money can be invested or withdrawn instantly. Temporary cash positions can cause returns to differ from the benchmark.
• Rebalancing timing: When an index changes its composition, the fund may not adjust at the exact same moment. Even small timing gaps can lead to deviations.
• Replication method: Funds that use sampling instead of holding all index securities may show small differences.
• Transaction costs: Brokerage and market impact costs further add to these gaps.

Why Does Tracking Error Matter?

Tracking error helps explain how a mutual fund behaves when compared with its benchmark.

• It helps explain why a fund’s returns may differ from its benchmark
• It shows whether these differences happen once in a while or regularly
• For benchmark-linked funds, it indicates how closely the fund follows what it is meant to track
• It is used to understand fund behaviour, not to judge returns
• It should be seen as one factor among many, not on its own

Tracking Error vs Similar Measures: Why Are They Often Confused?

Tracking error is often mixed up with other mutual fund measures because all of them deal with returns and benchmarks. However, each metric answers a different question.