Tracking error measures the degree to which the returns of an index fund or ETF deviate from the returns of its benchmark index over time. It is calculated as the standard deviation of the difference between the fund's returns and the index returns over a given period. A lower tracking error indicates the fund is closely replicating its benchmark — which is the primary objective of passive funds. Tracking error arises from several sources including fund management expenses (TER), cash drag from uninvested inflows, dividend reinvestment timing differences, securities lending income, and index reconstitution costs. In India, SEBI requires index funds and ETFs to disclose tracking error in their scheme information documents and fund fact sheets. Investors comparing two Nifty 50 index funds should select the one with lower tracking error (and lower TER) as the primary differentiating factor, since both funds by definition hold the same underlying stocks and cannot generate alpha through stock selection.
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