You bought an index ETF so you would get the index return. A year later, the index is up more than your ETF. Nothing went wrong with the market, yet your number is lower.
That gap has a name. Depending on how you measure it, it is called tracking difference or tracking error.
Many investors in our community mix up the two terms. Some ignore both and compare funds only on expense ratio, which can lead to the wrong choice.
This guide explains both measures and their causes. It also shows how to use them when picking an ETF or index fund. It is part of our pillar on US stocks and ETFs for Indian investors.
Two related guides in this cluster cover ETF NAV vs iNAV vs market price. They also cover why ETFs trade at a premium or discount.
At Belong, we check these numbers before recommending any passive fund. The process takes a few minutes once you know where to look.
Tracking Difference and Tracking Error: The Two Measures
These two terms sound alike but measure different things.
Tracking difference
Tracking difference is the gap between the fund's return and the index's return over a period. If the index returned more than the fund over one year, the tracking difference is negative.
It answers a simple question. How much less, or more, did I earn than the index?
HSBC Mutual Fund's periodic disclosures describe the schedule. Tracking difference is disclosed monthly on the AMC and AMFI websites. It covers tenures such as one, three, five and ten years.
Tracking error
Tracking error measures how consistent that gap is. It is the annualised standard deviation of the difference in daily returns between the fund and its index.
It answers a different question. Does the fund follow the index closely every day, or does it drift around?
The same HSBC disclosure document says tracking error is disclosed daily, based on past one-year rolling data. SEBI also sets a ceiling on it for ETFs and index funds, with exceptions reported to the trustees.
Why you need both
A fund can lag the index by a steady, small amount every day. That fund has a low tracking error but a negative tracking difference.
Another fund can swing above and below the index, ending the year close to it. That fund has a small tracking difference but a high tracking error.
Bajaj Finserv AMC's explainer makes the same point: the two metrics give different insights into how closely a fund followed its benchmark.
For a long-term investor, tracking difference usually matters more. It is the money you actually lose to the index. Tracking error tells you how reliable the fund's process is.
Tip: When comparing two ETFs on the same index, look at tracking difference over three and five years first. Then use tracking error to break a tie.
Why Your ETF Does Not Match the Index
An index is a list on paper. It has no costs, pays no taxes and never needs to trade. A fund holds actual securities and pays to trade them, and that creates gaps.
1. Expense ratio
The fund charges an annual fee. That fee comes out of the fund's assets, so the fund starts every year behind the index.
This is usually the largest and most predictable cause. Because of the time value of money, a small yearly drag grows into a larger gap over decades. Our guide on how to compare expense ratios explains how to read these fees across funds.
2. Trading costs
When the index changes its constituents, the fund must buy and sell stocks. It pays brokerage, taxes on transactions and the bid-ask spread.
The index records these changes instantly and at no cost. The fund cannot.
3. Cash drag
A fund keeps some cash to handle redemptions and expenses. It also receives dividends that sit as cash until reinvested.
That cash does not move with the index. When markets rise, idle cash pulls the fund's return down.
4. Dividend timing and treatment
Most Indian index funds are benchmarked to a total return index. That index assumes all dividends are reinvested immediately and in full.
The fund receives dividends later, and may receive less after costs. The wider principle is to look at what you actually keep. Our guide on why post-tax returns matter more than headline returns covers it.
5. Sampling instead of full replication
Some indices hold hundreds or thousands of securities, including illiquid ones. Buying every one in exact weights can be costly or impossible.
So some funds hold a representative sample instead. Sampling saves cost but adds tracking error, because the sample never moves exactly like the full index.
6. Index rebalancing
On rebalancing days, many funds tracking the same index trade the same stocks at the same time. Prices can move against them while they trade.
Funds tracking popular indices face this every time the index is reshuffled.
7. Currency, for international funds
An Indian fund tracking a US index has a rupee NAV, while the index may be calculated in dollars. The fund's return depends on both the US market and the rupee.
Compare the fund's rupee return with the index's dollar return, and you will see a large gap. That gap has nothing to do with fund quality. Always compare like with like.
The rupee's depreciation against the dollar can make the rupee return look better than the dollar index return. Our guide to currency risk in GIFT City funds explains this effect in detail.
8. Time zone and valuation timing
International fund NAVs are struck using foreign closing prices and an exchange rate taken at a fixed time. The index may use a different time.
These timing differences add day-to-day noise. They show up mostly in tracking error rather than in long-term tracking difference.
9. Fund structure
A fund of funds invests in another fund rather than directly in stocks. Two layers of costs can sit between you and the index.
Our guide on factors affecting returns in USD investments covers how structure and costs combine for global investments.
What This Means for ETFs vs Index Funds
ETFs and index funds tracking the same index face the same causes. But an ETF adds one more gap that tracking metrics do not show.
Tracking difference and tracking error are measured on NAV. As an ETF investor, you buy and sell at the market price.
Only market makers and large investors deal with the fund directly, in creation unit size. DSP's ETF scheme document explains this. Everyone else trades on the exchange.
Buy at a premium or sell at a discount, and your return can differ from the fund's NAV return. That gap is separate from tracking error and can be larger.
So for an ETF, you face two gaps:
Fund vs index: measured by tracking difference and tracking error.
Your price vs NAV: the premium or discount on the day you trade.
Our explainer on why ETFs trade at a premium or discount covers the second gap. For international ETFs listed in India in 2026, this second gap has often been far larger than tracking error.
Tip: A low tracking error does not protect you if you buy an ETF at a large premium. Check both before you invest.
How to Read Tracking Data Before You Invest
We use the following process. It works for ETFs and index funds.
List the funds tracking the same index.
Compare like with like. A Nifty 50 fund should be compared with other Nifty 50 funds only.Open the AMC or AMFI disclosure.
Find tracking difference for one, three and five years.Compare tracking difference first.
The fund that lagged the index least over several periods is usually the better tracker.Check tracking error next.
Lower and stable is better. A sudden jump deserves a question.Check the expense ratio.
It explains much of the tracking difference. If tracking difference is much worse than the expense ratio, ask why.Check fund size and trading volume.
For ETFs, low volume can mean wide spreads.For ETFs, check the premium or discount.
A good tracker bought at a high premium is still an expensive purchase.
Our guide to mutual fund performance tracking explains how to monitor your holdings after you invest. For evaluating returns over time, our comparison of rolling returns vs point-to-point returns is useful.
A worked comparison
Say two index funds track the same index. Fund A has a slightly lower expense ratio. Fund B charges slightly more.
Over five years, Fund B has lagged the index by less than Fund A. Its tracking error is also lower.
In this case, Fund B has done the better job despite the higher fee. Better execution, lower cash drag or tighter rebalancing can outweigh a small fee difference.
This is why expense ratio alone can mislead you. Our piece on low expense ratio vs a better fund manager explores the same trade-off.
Decision clarity
If two funds have similar tracking difference, choose the one with the lower expense ratio and better liquidity.
If one fund has clearly better tracking difference over several periods, it is usually the better choice. This holds even at a slightly higher fee.
If tracking error jumped recently, read the AMC's notes before investing.
If you are buying an ETF, check the premium or discount on the day you trade.
If your time horizon is long, small differences in tracking difference compound into a meaningful future value gap.
For Resident Indians Investing Globally
If you are a resident Indian, you can get US index exposure through several routes. Each has its own tracking profile.
Indian international funds and ETFs
These are rupee-denominated and often structured as funds of funds. Extra layers and currency conversion can widen tracking difference.
Compare them with the rupee version of the index where available. Comparing with the dollar index will give you a misleading gap.
GIFT City funds
GIFT City funds are denominated in US dollars. You can compare their returns with dollar benchmarks directly, without a currency layer.
You can browse options on our GIFT City mutual funds tool. One fund our resident users often review is the DSP Global Equity Fund. For regional exposure outside the US, there is also the Edelweiss Greater China Equity Fund.
Not every GIFT City fund is a passive tracker, so tracking error may not apply to all of them. For active funds, compare against a sensible benchmark instead. Our guides on benchmarks to compare GIFT City funds and how to evaluate GIFT City fund performance correctly explain how.
Direct US-listed ETFs
Large US-listed ETFs tracking major indices usually have very tight tracking. Investing in them requires LRS remittances and foreign asset disclosure.
Our guide on how to invest in the USA from India explains the full process.
For NRIs
If you are an NRI in Dubai or London, you probably buy ETFs through a local or international broker. The same two measures apply.
Compare ETFs on the same index using tracking difference over several years.
Domicile also matters. An Ireland-domiciled and a US-domiciled ETF on the same index can show different tracking differences. Fund structure and dividend handling vary by domicile.
When you compare returns across products in different currencies, convert them carefully. Our guide on how to compare USD investment returns correctly shows how.
For India exposure in dollars, NRIs often compare GIFT City funds. Two examples are the Tata India Dynamic Equity Fund and the Sundaram India Mid Cap Fund.
If you prefer fixed dollar returns, look at our USD fixed deposits. Our guide to GIFT City FD vs FCNR vs NRO and NRE FDs compares the choices. Current deposit options are on our NRI FD rates tool.
Common Mistakes With Tracking Error
One pattern we see often is investors switching funds after a single year of weaker tracking. Every switch has costs and possible tax. A one-year blip is rarely a reason to move.
Our guide on past returns vs consistency explains why steady results matter more than one good or bad year.
How Tracking Relates to Index Choice
Tracking only tells you how well a fund follows its index. It says nothing about whether the index suits you.
A perfect tracker of a narrow index can still be the wrong investment. Choose the index first, then the fund.
Our overview of global stock market indices explains the main options. For a wider view of costs beyond fees, our guide to hidden costs in NRI investments is also useful.
The same tracking idea applies to other instruments. GIFT Nifty futures follow the Nifty with a gap that reflects time and interest costs. Our GIFT Nifty tool shows it live.
For more on reading that gap, see our guides to GIFT Nifty futures and the GIFT Nifty chart explained. Our GIFT Nifty historical data and weekly GIFT Nifty outlook add context over time.
Before You Choose Any Passive Fund
Tracking error is a detail. Your financial base matters more.
Clear expensive debt and keep your CIBIL score healthy. If you spend abroad, compare forex markups in our guide to the best credit cards in India.
If you are an NRI with an NRI home loan, plan your rupee commitments before adding dollar assets. For your Indian equity core, our view on the best stocks in India is a reasonable starting point.
You can explore our mutual fund offering for managed exposure. Larger investors can compare strategies on our GIFT City AIF tool.
If you trade derivatives, learn the mechanics first, then see our futures and options offering. For new listings, read our guide to GIFT City IPOs or see our IPO offering.
Selling funds has tax consequences, and global holdings add reporting duties. Our tax filing service can help. Our regulatory registrations are on our licences page.
FAQs on ETF Tracking Error
What is a good tracking error for an ETF?
Lower is better, and stable is better than volatile. SEBI sets a ceiling on tracking error for ETFs and index funds, and AMCs disclose it daily.
Compare a fund's tracking error with other funds on the same index, not with funds on different indices.
Is tracking error the same as tracking difference?
No. Tracking difference is the return gap between the fund and its index over a period.
Tracking error measures how much that gap varies day to day. For long-term investors, tracking difference usually shows the cost more clearly.
Where can I find tracking error data in India?
AMCs publish tracking error daily and tracking difference monthly on their websites and on the AMFI website. HSBC Mutual Fund's disclosure document describes this schedule.
Scheme factsheets often include these figures too.
Can an ETF beat its index?
Occasionally, over short periods. Securities lending income, favourable trading or rounding can produce a small positive gap.
It rarely lasts. Do not choose a passive fund expecting it to beat its index.
Does tracking error affect NRIs differently?
The measures are the same for everyone. NRIs comparing funds in different currencies or domiciles need extra care.
Compare funds in the same currency and on the same index. Domicile can change how dividends are treated inside the fund.
Sources
HSBC Mutual Fund, Periodic disclosures including tracking error and tracking difference: https://www.assetmanagement.hsbc.co.in/assets/documents/mutual-funds/en/d0c90c3c-882c-4fc2-a598-d6ccd0fb702c/periodic-disclosures.pdf
Bajaj Finserv Asset Management, Tracking difference vs tracking error: https://www.bajajamc.com/knowledge-centre/tracking-difference-vs-tracking-error
DSP Mutual Fund, DSP Nifty 50 ETF scheme information: https://www.dspim.com/media/pages/mandatory-disclosures/simplified-sid-information-available-through-weblink/bf09ea359b-1764359464/dsp-nifty-50-etf.pdf
Disclaimer
This article is for educational purposes only and is not investment, tax or legal advice. Tracking error limits, disclosure rules and fund terms can change.
Always check the latest scheme documents and AMC disclosures before investing. Investments in ETFs and mutual funds are subject to market and currency risk.