What is tracking error? Why does it occur?
The extent to which the index fund does not track the index properly is known as tracking error. It is the difference between a fund’s portfolio returns and the benchmark it was designed to track during the investment period. Low tracking error means a portfolio is closely following its benchmark.
Reasons for occurrence of tracking error:
- Index is a dynamic combination and the constituents change. Till the time the fund manager also adjusts the fund holdings accordingly, there will be tracking error present in the fund.
- Expense ratio of the fund also drags down the overall performance. A fund with a low expense ratio may have a higher tracking error because it doesn’t closely track the underlying index or redemption pressure.
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