Tracking Error: The Hidden Cost of Passive Investing

Cash received from fresh investor inflows may remain temporarily uninvested, preventing the fund from fully participating in market movements. Dividend treatment also contributes to the error. Benchmark indices assume dividends are reinvested on the ex-dividend date. Fund managers receive the cash dividend only after two to three weeks before reinvesting it, leaving part of the portfolio underinvested during that period.

The type of benchmark being tracked also influences tracking error. Large-cap indices such as the Nifty 50 and BSE Sensex generally exhibit lower tracking error because their constituent stocks are highly liquid and index changes are relatively limited. Conversely, mid-cap, small-cap, and factor-based smart beta indices tend to experience higher tracking error. Kaswa pointed out that mid-cap indices encounter substantial portfolio churn when top-performing companies graduate to large-cap status, causing relatively large portfolio weights to exit simultaneously. That higher turnover, combined with lower stock liquidity, naturally widens execution gaps.

Tracking error directly affects investors' returns. Amol Joshi, founder of PlanRupee Investment Services, said, "Investors would typically choose a scheme that has consistently lower tracking error while accepting the fact that tracking error is inevitable due to the realities of the market."

When selecting an index fund or ETF, investors should look beyond headline returns. Comparing rolling one-year tracking errors among funds tracking the same benchmark can help identify schemes that have consistently mirrored their indices more closely. Lower tracking error signals better execution and greater consistency, qualities that matter in passive investing, where the objective is to replicate, not outperform, the benchmark.