Since passive funds, such as index and exchange-traded funds, are mandated to mimic their benchmark indices, there’s no straight-forward way to tell which index fund is better than the other. One of the very few ways to see how good or bad an index fund is its tracking error (TE).
What is TE? The deviation of an index fund’s performance from its benchmark index is measured by a number called TE. Passive funds incur TE for several reasons. They pay commission to brokers to buy and sell scrips that increased their costs that eventually reduce their net asset values. Cash holdings also contribute to TE as higher TE affects performance. The lower the TE, the better is a passive fund.
Disclosure standards: The capital market regulator, the Securities and Exchange Board of India, mandates a disclosure of several portfolio attributes that enables investors to track their mutual fund investments efficiently. Unfortunately, TE is not one of them. Different fund houses have different standards; some disclose every month diligently and others conveniently avoid doing it. The periodicity of calculation also differs; some give one-year TE, others give three-year TE.
The solution: A TE of up to 2% is generally acceptable, though few index funds cross this limit. As TE is the best indicator to differentiate one index from another, a regular and standardized disclosure helps.