Tracking Error is defined as the difference in return between an Index Fund and its target benchmark. For an Index Fund, the return generated should ideally match with its benchmark returns. However, there is a difference between the two. This is due to the tracking error. It is depicted as a percentage.
Tracking Error is a key differentiator while selecting an Index mutual fund and some of the points to note are:
a. Tracking error can be due to the fund expenses, changes in cash levels, difference in underlying securities, corporate actions or restriction on buying-selling a specific stock
b. A small tracking error means that the fund is following its benchmark very closely (and vice versa)
c. While choosing an index fund, the one with the lowest tracking error would be a better choice
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