Of tracking error and tracking difference

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Expenses: Passive funds charge TER to cover management and operating expenses associated with managing the fund. A higher or lower TER has a direct impact on the fund returns. Cash holdings: Passive funds also hold a certain percentage of AUM in cash and cash equivalents (usually liquid securities) to honour investor redemptions.

Since this amount is not invested, it may drag or add to the fund returns in rising or falling markets. Securities lending: Passive funds may also have a source of revenue over and above the returns of the index. They can lend securities held by them to other market participants for a limited period in exchange for a fee.

The additional revenue generally helps reduce costs and improve tracking difference. Execution timing: Several stocks get added or removed during an index rebalance. While the index uses closing day prices for return calculation, in reality, fund managers may not be able to execute transactions exactly at the closing prices.

This causes a slight mismatch in the execution price, causing tracking difference. This is also applicable for daily investor’s cash flow management. Delay in receipt of dividend: When a fund receives dividends from the underlying securities, there is a timing difference between when the fund receives the payout and when the benchmark index accounts for those payments, which might add to the tracking difference.