Passive investing involves buying index funds or ETFs to mirror market returns, but performance gaps are inevitable due to market frictions. According to Amol Joshi, founder of PlanRupee Investment Services, tracking error is the difference between scheme performance and its benchmark, while tracking difference measures the gap between fund returns and benchmark returns over specific periods. As explained by Mahavir Kaswa, head of passive research at Axis Mutual Fund, tracking error represents the annualized standard deviation of daily returns between the underlying index and the scheme, highlighting day-to-day variability of return differences. Both metrics show lower is always better, with unexpected positive differences potentially signaling unwanted strategy deviation.
Even efficient passive fund managers face practical market frictions that create tracking error. According to Kaswa, expense ratios, brokerage charges, securities transaction tax (STT) and other transaction costs immediately create a drag on returns. Fund managers execute portfolio changes during market hours—typically in the last 30 minutes before close—which can result in execution price differences compared to benchmark providers' closing price assumptions. Additionally, cash received from fresh investor inflows may remain temporarily uninvested, preventing full participation in market movements, while dividend treatment contributes to tracking error as fund managers receive cash dividends only after two to three weeks before reinvesting them. As per latest reports, these frictions directly impact index funds and ETFs by influencing their performance relative to their benchmarks.
Tracking error varies significantly based on benchmark type, with large-cap indices like Nifty 50 and BSE Sensex generally exhibiting lower tracking error due to highly liquid constituent stocks and relatively limited index changes. Conversely, mid-cap, small-cap and factor-based (smart beta) indices tend to experience higher tracking error due to rule-based strategies selecting stocks based on factors such as value, momentum or quality. As noted by Kaswa, mid-cap indices encounter substantial portfolio churn with top-performing companies graduating to large-cap status, causing relatively large portfolio weights to exit simultaneously. Lower liquidity and more frequent index rebalancing make it harder for fund managers to replicate these benchmarks precisely. According to recent analysis, this benchmark type variation directly impacts how closely funds track their intended indices.
Tracking error has direct impact on investor returns, with consistency in benchmark tracking remaining an important measure of fund quality. According to Joshi, investors typically choose schemes with consistently lower tracking error while accepting that tracking error is inevitable due to market realities. When selecting index funds or ETFs, investors should compare rolling one-year tracking errors among funds tracking the same benchmark to identify schemes that have consistently mirrored their indices more closely. Lower tracking error signals better execution and greater consistency, qualities that matter in passive investing where the objective is to replicate, not outperform, the benchmark. As per latest market data, a tracking error of less than 2% per annum is considered acceptable for index funds and ETFs, though investors should assess their risk tolerance and investment strategy when evaluating tracking error.
