What Is Tracking Error in Indian Index Funds and ETFs? A Simple Investor Guide
When you invest in an index fund or ETF in India, you expect it to mirror the performance of the market index it’s supposed to follow-like the Nifty 50 or Sensex. But here’s the catch: it rarely matches perfectly. That gap between what the index returns and what your fund returns is called tracking error. It’s not a bug. It’s a feature of how these funds work. And if you don’t understand it, you could be losing money without even realizing it.
Why Tracking Error Matters for Indian Investors
In India, index funds and ETFs have exploded in popularity over the last five years. More than ₹4.5 lakh crore is now invested in passive funds, according to AMFI data from early 2025. That’s up from just ₹1.2 lakh crore in 2020. But not everyone knows that even the best-managed index funds don’t deliver the exact return of the index. Why? Because of tracking error.
Imagine you buy an ETF that tracks the Nifty 50. The index goes up 12% in a year. Your ETF only goes up 11.3%. That 0.7% difference is your tracking error. Sounds small? Over 10 years, that adds up. A 0.7% annual drag on returns can cost you more than 7% of your total wealth compared to holding the index directly.
Tracking error isn’t about bad management. It’s about physics-money moving, taxes, fees, and how markets actually work.
What Causes Tracking Error in Indian Funds?
Tracking error comes from five main sources, and all of them are very real in the Indian market:
- Cash drag: Index funds need to hold some cash to pay for redemptions. If the market is rising, that cash sits idle and drags returns down. Most Indian index funds keep 1-3% in cash, which can cost you 0.2-0.6% annually in a bull market.
- Transaction costs: Every time the index changes-like when a stock gets added or removed from the Nifty-the fund has to buy or sell shares. Brokerage, stamp duty, and SEBI fees add up. In India, stamp duty alone is 0.015% on every trade. Multiply that by dozens of trades per quarter, and you’ve got a hidden cost.
- Dividend timing: When a stock in the index pays a dividend, the index immediately drops by that amount. But your fund doesn’t get the cash right away. It takes 2-3 days to collect dividends and reinvest them. That delay creates a small but consistent drag.
- Fund size and liquidity: Smaller ETFs struggle to trade large blocks of illiquid stocks. For example, if your ETF holds a mid-cap stock that trades only 50,000 shares a day, but the fund needs to buy 200,000 shares, the fund has to pay higher prices. That’s called slippage. It’s a bigger problem in India than in the U.S. because liquidity is thinner.
- Expense ratio: Every rupee you pay in fees is a rupee you don’t earn. An index fund with a 0.2% expense ratio will underperform its index by at least that much-before any other costs.
Some of these factors are unavoidable. Others? You can avoid them by choosing wisely.
How to Spot Low-Tracking-Error Funds in India
Not all index funds are created equal. Some have tracking errors under 0.1%. Others creep past 1%. Here’s how to find the good ones:
- Check the fund’s fact sheet: Every mutual fund in India publishes a monthly fact sheet. Look for the line labeled “Tracking Error” or “Deviation from Benchmark.” If it’s not listed, skip the fund.
- Compare 3-year tracking error: A fund with a 0.15% tracking error over three years is better than one with 0.4%. Don’t just look at the one-year number-volatility can hide the real trend.
- Look at fund size: Larger funds usually have lower tracking error. Nippon India ETF Nifty 50 (₹18,000+ crore AUM) has a 3-year tracking error of 0.08%. A smaller fund with ₹500 crore AUM might be at 0.6%.
- Prefer ETFs over regular index funds: ETFs trade on exchanges and use in-kind creation/redemption. This reduces cash drag and transaction costs. Most ETFs in India have lower tracking error than their mutual fund counterparts.
- Avoid funds with high turnover: If a fund rebalances more than twice a year, it’s likely paying more in fees. The Nifty 50 changes only 5-8 stocks annually. Any fund rebalancing more often is probably chasing noise.
As of 2025, the top three low-tracking-error ETFs in India are:
| ETF Name | Underlying Index | Tracking Error | AUM (₹ Crore) | Expense Ratio |
|---|---|---|---|---|
| Nippon India ETF Nifty 50 | Nifty 50 | 0.08% | 18,200 | 0.05% |
| ICICI Prudential Nifty ETF | Nifty 50 | 0.10% | 12,500 | 0.05% |
| SBI ETF Nifty 50 | Nifty 50 | 0.11% | 9,800 | 0.05% |
Notice something? All three have the same expense ratio. But their tracking error differs. That’s because of how well they manage cash, dividends, and trades-not because one is “better.”
When Tracking Error Is a Red Flag
Tracking error isn’t always harmless. If you see a fund with:
- Tracking error above 0.5% for a broad-market index like Nifty 50
- Consistently higher tracking error than its peers over 3+ years
- No published tracking error data
Then you’re likely paying for active management without getting active returns. That’s a trap.
Some funds market themselves as “enhanced index funds” or “smart beta.” They promise to beat the index. But they charge higher fees and take on more risk. If your goal is low-cost, passive exposure, avoid them. Stick to pure index trackers.
What You Can Do Today
You don’t need to be a finance expert to reduce tracking error. Here’s your action plan:
- Check your current index fund or ETF’s fact sheet. Find the tracking error number. If you can’t find it, call the fund house or visit their website.
- Compare it to the top three ETFs listed above. If yours is more than 0.2% higher, consider switching.
- Use ETFs for long-term holdings. They’re cheaper and more precise.
- Never chase low expense ratios alone. A fund with 0.03% fees but 0.8% tracking error is worse than one with 0.05% fees and 0.1% tracking error.
- Rebalance your portfolio annually. Don’t let tracking error creep up silently over time.
Tracking error is invisible. But it’s real. And it’s eating your returns right now.
Final Thought: Passive Doesn’t Mean Set-and-Forget
Index investing is the smartest way for most people to build wealth in India. But being passive doesn’t mean being careless. You still need to pick the right tools. Tracking error is the quiet thief that steals returns slowly, year after year. Don’t let it go unnoticed.
The difference between a fund with 0.1% tracking error and one with 0.5%? Over 20 years, that’s tens of lakhs in lost gains. Choose wisely. Your future self will thank you.
What is a good tracking error for an Indian index fund?
For broad-market index funds tracking the Nifty 50 or Sensex, a tracking error below 0.2% is excellent. Between 0.2% and 0.5% is acceptable. Anything above 0.5% is too high for a passive fund and suggests poor execution or unnecessary costs.
Is tracking error the same as expense ratio?
No. Expense ratio is the annual fee you pay to run the fund. Tracking error is the difference between what the fund returns and what the index returns. Expense ratio contributes to tracking error, but it’s not the only factor. Cash drag, trading costs, and dividend timing also play major roles.
Why do ETFs have lower tracking error than index mutual funds?
ETFs use an in-kind creation and redemption process. Authorized participants exchange baskets of stocks for ETF shares, avoiding cash transactions. This reduces cash drag and trading costs. Mutual funds, on the other hand, often buy and sell shares with cash, which increases friction and tracking error.
Can tracking error be negative?
Yes. Negative tracking error means the fund outperformed the index. This can happen if the fund earns extra income from lending securities (common in ETFs) or if it holds cash that earns interest while the market is flat. But sustained negative tracking error is rare and usually temporary.
Should I avoid index funds with high tracking error entirely?
Not necessarily. If the fund has other advantages-like lower minimum investment, easier SIP access, or better customer service-it might still be worth holding. But if you’re building a long-term portfolio, always prefer funds with the lowest tracking error. Your returns will thank you.