12.7 Tracking Error and Scheme Performance Disclosure
Key Takeaways
- Tracking error is the standard deviation of the difference between scheme and benchmark returns.
- Tracking difference is the simple return gap, while tracking error measures its variability.
- Low tracking error is the objective for a passive scheme, not outperformance.
- Tracking error arises from expenses, cash holdings, rebalancing costs and dividend timing.
- AMCs must disclose scheme performance in prescribed formats, including all schemes managed by a fund manager.
Tracking Error
Tracking error is the standard deviation of the difference between a scheme's returns and its benchmark's returns over a period. It measures how consistently the scheme follows the index, not how far behind it is.
A closely related but distinct measure:
| Measure | Definition |
|---|---|
| Tracking difference | The simple gap between scheme return and benchmark return |
| Tracking error | The standard deviation of that gap over time |
A fund that trails its index by exactly 0.35% every single month has a large tracking difference and a very small tracking error, because the gap is entirely predictable. A fund whose gap swings between +2% and -2% has a small average difference and a large tracking error. For a passive investor the second is far worse, because the scheme is not reliably delivering the index.
Why Tracking Error Exists
Even a perfectly managed index fund cannot match its index exactly:
| Source | Effect |
|---|---|
| Expense ratio | The scheme bears costs; the index bears none |
| Cash holdings | Cash for redemptions is not invested in the index |
| Rebalancing costs | Brokerage, impact cost and levies when the index changes |
| Dividend timing | The index assumes immediate reinvestment; the scheme reinvests with a lag |
| Inflows and outflows | Deployment and liquidation occur at prices that differ from index levels |
| Sampling | Some funds hold a representative subset rather than every constituent |
Because the expense ratio is a permanent drag, a passive scheme is expected to return slightly less than its total return benchmark, and the size of that shortfall is the measure of how well the scheme is run.
Evaluating a Passive Scheme
The criteria differ fundamentally from those for an active scheme:
| Active scheme | Passive scheme | |
|---|---|---|
| Objective | Beat the benchmark | Match the benchmark |
| Success measure | Alpha, information ratio | Low tracking error, low tracking difference |
| Expense ratio | Weighed against alpha | Should be as low as possible |
| Manager skill | Central | Largely irrelevant; execution quality matters |
| Outperformance | Desirable | A warning sign of unintended deviation |
That final row is counter-intuitive and examinable: an index fund that beats its index has deviated from it, which means it is not doing its job. The investor bought the index and received something else.
When comparing two index funds tracking the same index, the ranking is straightforward: lower expense ratio and lower tracking error. There is very little else to distinguish them.
Tracking Error in Active Schemes
Tracking error also applies to active schemes, where it measures active risk — how far the manager departs from the benchmark.
- Very low tracking error in an actively managed scheme suggests a closet index fund: the investor pays active fees for near-index exposure.
- Very high tracking error indicates aggressive deviation, which may or may not be rewarded.
The information ratio — excess return divided by tracking error — assesses whether the deviation earned its keep.
Scheme Performance Disclosure
SEBI prescribes how performance must be published, so that the record is complete and comparable.
Content requirements:
- Performance for the prescribed periods, commonly one, three and five years and since inception
- Benchmark returns for the identical periods, on a Total Return Index basis
- Absolute returns for periods of less than one year; compounded annualised returns thereafter
- Point-to-point returns on a standard investment amount
- The caution that past performance may or may not be sustained
Completeness requirements:
- Performance of all schemes managed by the same fund manager must be disclosed, so an investor sees the manager's full record rather than only the strongest scheme
- Performance of all schemes of the AMC, in the prescribed format on the website
- Disclosure requirements prevent selective survivorship, so discontinued or merged schemes cannot simply vanish from the presented record
- Where the benchmark or fundamental attributes changed, the presentation must make that visible
Where it is published:
- The AMC website, in the prescribed format
- Fact sheets and scheme documents
- Advertisements, subject to the advertisement code
The Fund Manager Disclosure Is the Useful One
Of all these requirements, the obligation to disclose every scheme managed by the same fund manager is the one a distributor should actually use. A manager presented as outstanding on the strength of one scheme may run four others that have lagged. The disclosure makes the full record visible, and checking it takes a minute.
What to Check When Reviewing Performance
- Is the comparison against the prescribed Tier 1 benchmark, on a TRI basis?
- Are the periods the prescribed ones, or a window that flatters?
- Has the benchmark changed during the period shown?
- For a passive scheme, what are the tracking error and tracking difference?
- For an active scheme, what is the information ratio, and is tracking error so low that it is effectively an index fund?
- What is the fund manager's record across all schemes managed?
Index Fund A trails its benchmark by almost exactly 0.30% every month. Index Fund B's monthly gap swings between +1.8% and -1.8%. Which is the better passive vehicle and why?
An actively managed equity scheme has a very low tracking error against its benchmark. What does this suggest?
Which disclosure requirement most helps an investor assess a fund manager rather than a single scheme?