Explainer: What is Tracking Error in mutual funds and what it means for investors

economictimes.indiatimes.com:

Tracking error is the difference between the scheme’s return and that of the benchmark index. It measures how closely a mutual fund scheme has replicated the returns of its benchmark index. The larger the deviation is from its benchmark index returns, the higher the tracking error of the scheme.

According to AMFI, tracking error is the difference between an ETF portfolio's returns and the benchmark or index it was meant to mimic or beat.

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ETFs and index funds, much like other mutual fund schemes, incur expenses on cost heads, such as marketing, advertising, office administration, brokerage and so on. These expenses reduce the ETF’s returns. The ETF may also receive dividends from the underlying stocks which may temporarily lead to the ETF out-performing the benchmark. This deviation in performance is nothing but the “tracking error” and is expressed in percentage terms. Tracking error is sometimes called active risk. How well an index fund manages its inflows and outflows also determines tracking error. The lower the tracking error, the better the ETF / Index fund, according to AMFI.

Tracking error = standard deviation of (P-B)

Where, P = portfolio return
B = benchmark return
A low tracking error indicates that the fund closely follows its benchmark, while a high tracking error suggests greater deviation.

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