Will all Nifty 500 index funds have poor tracking differences?

I regularly review fact sheets of the mutual funds I invest in. I take note of some metrics to keep track of the funds’ health and performance. Starting this month, I have started noting down tracking differences of index funds.

3 years tracking difference of some popular index funds:

• HDFC Nifty 50: 0.31 pp (percentage points)
• UTI Nifty 50: 0.42 pp
• Motilal Oswal Nifty 500: 1.36 pp

I was a little disappointed to see these numbers since Motilal Oswal Nifty 500 is the fund I have chosen for my portfolio. Looking at these numbers, predictions of the Motilal Oswal fund not being able to closely track its index seemed to have come true.

The linked article says that tracking 500 stocks will be more difficult than tracking 50 stocks due to impact cost and other overhead. It goes on to recommend that investors stick to Nifty 50 index funds.

If tracking 500 companies has such an impact, I wondered, what the story will be for funds that track thousands of companies? So I looked at 2 Vanguard ETFs tracking global indices. Despite holding thousands of stocks, these funds had incredibly low tracking differences.

Fund name	Stocks held	3 years tracking diff.
HDFC Nifty 50	50	0.31 pp
UTI Nifty 50	50	0.42 pp
Motilal Oswal Nifty 500	500	1.36 pp
Vanguard All-World (VWRA)	3700+	0.10 pp
Vanguard Total World Stock (VT)	9800+	0.52 pp

This busts the theory that tracking more companies will always lead to a higher tracking difference. A competent fund manager like Vanguard can replicate large indices without deviating too far away from the index.

This made me think of the Jio-BlackRock joint venture that is expected to launch mutual funds in the near future. BlackRock’s iShares MSCI World ETF had managed a 3-years tracking difference of -0.47 pp despite holding a large portfolio of stocks. A Nifty 500 fund run by BlackRock would likely have a low tracking difference, I thought. Then I discovered iShares MSCI India ETF, so I looked at this ETF’s tracking difference.

The tracking difference of the MSCI India ETF is more than 10 percentage points! This looks even worse when you consider that this ETF only holds 136 companies, possibly very liquid large- and mid-cap companies.

Takeaways for me:

• While Motilal Oswal Nifty 500 has a mildly high tracking difference, it’s not that bad. There are worse options out there.
• BlackRock coming to India need not be as amazing as some hype it up to be. We have to wait and see how they are able to perform.
• Finally, some Nifty 50 index funds also have high tracking differences. NiftyBeES, India’s most popular Nifty 50 ETF, has a tracking difference of 0.98%. ABSL Nifty 50 and DSP Nifty 50 funds have tracking differences of 1.32 pp and 1.22 pp respectively. Compared to that, Motilal Oswal Nifty 500’s 1.36 pp is very respectable.

Index fund tracking error vs tracking difference

Tracking error and tracking difference are 2 metrics for assessing mutual funds that mirror an index. Let’s look at the difference between the 2 with an exaggerated hypothetical example.

Imagine there are 2 funds, Fund A and Fund B, both mirroring the same index. Let's pretend the index and the funds start at the value of 100 at time T₀ and go through the following changes over time.

Absolute value of an index and 2 funds tracking it

Timestamp	Index	Fund A	Fund B
T0	100.00	100.00	100.00
T1	101.54	101.14	101.52
T2	101.11	100.32	101.04
T3	101.10	99.90	101.01
T4	101.88	100.27	101.70
T5	102.31	100.29	102.16

Which fund do you think has a higher tracking error? Many investors would be surprised to hear that Fund A’s tracking error is 0.71% but Fund B’s tracking error is 2.95%.

Tracking difference vs tracking error?

Tracking difference is easy to understand and calculate. Take any time period. Find the difference between index return and fund return. That number is the tracking difference for that period. Tracking error, on the other hand, is a metric that tells us how consistent a fund’s tracking differences have been.

Let’s go back to our hypothetical example. The following table shows tracking difference for each time period.

Tracking differences of 2 hypothetical index funds

Time period	Fund A	Fund B
T0–T1	0.40 pp	0.02 pp
T1–T2	0.39 pp	0.05 pp
T2–T3	0.41 pp	0.02 pp
T3–T4	0.40 pp	0.09 pp
T4–T5	0.40 pp	0.03 pp

As you can see, Fund A’s tracking differences have fallen in a narrow range of 0.39 percentage points to 0.41 percentage points. But Fund B’s tracking differences are spread across a wider range of 0.02 percentage points to 0.09 percentage points.

Tracking error is the standard deviation of all tracking differences of the fund. If the tracking differences are similar throughout the assessment period, that fund has a low tracking error. This is independent of the quantum of the tracking difference.

Index fund metrics for the time period T₀–T₅

	Fund A	Fund B
Tracking difference	2.02 pp	0.71 pp
Tracking error	0.15 pp	2.95 pp

What is important? Tracking error or tracking difference?

In a way, both are important. But tracking difference is a lot more important than tracking error.

• A lower tracking difference over a long duration (such as 10 years) means that the return an investor earns is similar to the return the index earns. That is always a good thing.
• A lower tracking error means that the process used by the fund management team can reliably replicate the index in all circumstances. Securities markets have good days and bad days. If a fund is able to replicate the index with a similar kind of tracking difference on all days, it means the fund follows a robust investment process.

How to choose an index fund?

1. Choose the index that you want to invest in. My older posts Nifty 50 vs Nifty 500 or Not all index investing is passive may be of some help.
2. If you have multiple funds mirroring your chosen index, then pick the one that has consistently low tracking difference over different time periods.
3. If you still have multiple options to choose from, you can choose the fund with a lower tracking error.

But this is not foolproof. You should also appreciate and accept that we can only do Step 1 above reliably. The other 2 metrics—tracking difference and tracking error—are moving targets. A fund that has done well for many years may suddenly start to falter, or vice versa.

Do your best to choose a fund. But don’t panic or blame yourself if you make a judgement error. Just see how to course correct since that’s the only thing we can do after investing in a suboptimal fund.

Thanks to FreeFinCal for making me aware of the significance of tracking difference.