General

What is tracking error and tracking difference?

Tracking difference:It is the difference between the 1-year return of an ETF as compared with that of its underlying asset/index. Let’s say the NIFTY gave an annual return of 10% while a NIFTY ETF gave a return of 9.8%; this difference of 0.2% is called the tracking difference.

Tracking error:It is the rate at which the difference between the rate of return of an ETF and the rate of return of the underlying asset/index changes in one year. In other words, this shows how well the ETF reflects the performance of the underlying asset/index. This is measured as the standard deviation percentage difference.

Let’s say the NIFTY gave an annual return of 10% while a NIFTY ETF gave a return of 9.8%. The tracking difference in this case; whereas the tracking error quantifies how often this difference fluctuates around that 0.2% mark.

There can be the following possible reasons for tracking error and tracking difference:

1. Expenses: The management fee, brokerage and transaction costs (including statutory charges) directly reduce the returns

2. Operations: Buying/selling slippages, bid-ask spreads or rebalancing may cause divergence from index return.

3. Corporate actions and index changes: Corporate actions such as splits, mergers, demergers and right issues require adjustment that may not be instantaneous and hence may lead to temporary mismatches.