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.
| 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.
| 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.
| 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?
- 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.
- If you have multiple funds mirroring your chosen index, then pick the one that has consistently low tracking difference over different time periods.
- 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.
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