Tracking Error vs. Tracking Difference: The Guide Every Index Fund/ETF Investor Needs

Let’s say you invested in an index fund or an ETF since you want to track the underlying market index. The fund's job is to replicate the index's performance, giving you a way to track the underlying index.When you start researching about the funds you want to invest in - you might have come across two different terms: Tracking Error and Tracking Difference.

They seem to be the same, but they measure two completely different things. Understanding this difference is crucial to knowing if your "simple" index fund/ETF is actually tracking the index accurately or not.

Here’s a simple breakdown:

• Tracking Difference measures how much your fund's final performance differed from the index's performance. It is an annualized difference that is disclosed only after a year since inception.
• Tracking Error is the annualized standard deviation of the difference between the fund's returns and the benchmark's returns.

The "Driving" Analogy

This is the easiest way to lock in the concept.

Imagine the Index is the lead car in a convoy. Your Fund is the car right behind it, and the fund’s job is to follow it perfectly.

• Tracking Difference: At the end of the 100-mile trip, the lead car is at mile marker 100. You are at mile marker 99.8. Your Tracking Difference is -0.2 miles. It’s the simple, final gap in performance.
• Tracking Error: This measures how much you swerved during the trip. Did you stay perfectly in the lane, 100 feet behind the lead car the entire time? (Low Tracking Error). Or were you constantly swerving, accelerating, and braking, nearly hitting the guardrail, even though you happened to end up just 0.2 miles behind? (High Tracking Error).

You want a driver who doesn't swerve and who stays close.

What is the Tracking Difference? (The "How Much")

Tracking Difference is the performance gap.
It’s the simple, annualized difference between the fund's total return and the index's total return.

Here’s the official definition you'll see in fund documents:

“Tracking Difference” is the annualized difference of daily returns between the Index and the NAV of the scheme (difference between fund return and the benchmark return).”

Example:

• Nifty 50 Index Return (1 year): 10.0%
• Your Nifty 50 Index Fund's Return (1 year): 9.7%
• Tracking Difference: -0.3%

This -0.3% is the "cost" of your investment that goes beyond just the performance. It's the most important number for a long-term, buy-and-hold investor because it directly shows how much performance you "lost" compared to the pure index.

What causes it?

• Fees: This is the biggest one. Your fund has an expense ratio, which is a direct drag on performance.
• Transaction Costs: When the index is rebalanced (constituents are added or removed), it incurs a transaction cost.
• Cash Drag: The fund has to hold some cash to meet redemptions. This cash "drags" on performance in a rising market.

What is Tracking Error? (The "How Consistently")

Tracking Error is the measure of volatility or consistency.

It does not tell you how much the fund underperformed. It tells you how predictable the fund's journey was in relation to the index.

Here’s the official definition:

“Tracking Error” is defined as the annualized standard deviation of the difference in daily returns between the underlying index and the NAV of the ETF/ Index Fund

In simple terms, "standard deviation" is a statistical measure of the "wobble." A low tracking error means the fund moves in lock-step with the index every single day. A high tracking error means the fund’s daily returns were all over the place.

Why You Must Care About Both: Two Scenarios

This is where it all comes together. Let's look at two funds that both ended the year with the exact same -0.5% Tracking Difference.

Scenario 1: Fund A 

• Tracking Difference: -0.5%
• Tracking Error: 0.02% (Very Low)
• What happened? The fund lagged the index by a tiny, predictable amount every single day. This lag was almost entirely due to the fund's expense ratio.

Scenario 2: Fund B 

• Tracking Difference: -0.5%
• Tracking Error: 0.80% (High)
• What happened? This fund’s replication approach was inconsistent. Some days the fund beat the index by 0.3%, other days it lagged by 0.4%. The fund may have experienced higher deviation due to sampling strategy or execution inefficiencies. By pure luck, all these daily swings canceled each other out to land at a -0.5% difference for the year.
• A high tracking error means the fund is unpredictable. Next year, it might not, and that -0.5% tracking difference may widen if the inconsistency persists.

The Investor Takeaway

When you're choosing an index fund, you want both numbers to be as low as possible.

1. Prefer funds with a low Tracking Difference. This tells you the fund is efficient and isn't letting fees, cash drag, or trading costs eat away at your total return.
2. Prefer funds with a low Tracking Error. This tells you the fund is actually doing its job of replicating the index predictably. It proves the manager is running a tight ship and that the low tracking difference isn't just a lucky outcome.

Disclaimer - Please note that this article or document has been prepared on the basis of internal data/ publicly available information and other sources believed to be reliable. The information contained in this article or document is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party in any manner. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article or document.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.