Measurement of Tracking Error Based on Category Index - The Hidden Cost of Index Funds

Purpose of the study: The paper aims at finding how effectively the index funds in India are being able to observe the strategy ‘indexing’, setting tracking error as the critical factor. Background of the study: The belief that financial markets are efficient and it is therefore impossible to consistently beat the aggregate market has led to the emergence of passive portfolio management and index funds. Less efforts have been directed towards measuring the effectiveness of index funds, as regards indexing strategy. This paper is written to fulfill this gap. Methodology: Broad category index has been used to measure the tracking error depicted by the index funds. Various formulae have been used to gauge the measure of tracking error. Results: Tracking error exhibited by the index funds are significantly higher than the level of tracking error, accepted globally. Findings: It is found that buffer cash for redemption pressure and higher management fees of the index funds in India, are the major factors contributing to higher level of tracking error.