Investor Corner/The asset classes/Mutual Fund Core Concepts
2.3.12 Index Funds & ETFs
Index funds and ETFs aim to replicate a market index at very low cost, rather than trying to beat it. Tracking error measures how closely a fund actually manages to follow the index it is meant to mirror.
Matching the market instead of trying to beat it
An index fund buys the same securities as its target index, in roughly the same proportions, so its performance should closely mirror that index minus a small cost for running the fund. This is a fundamentally different goal from an actively managed fund, which is trying to outperform its benchmark rather than simply match it.
ETFs versus index mutual funds
An ETF, or exchange-traded fund, follows the same passive philosophy as an index fund but trades on a stock exchange throughout the day like a share, requiring a demat and trading account. An index mutual fund is bought and sold at end-of-day NAV like any other mutual fund, without needing a trading account. The underlying strategy behind both can be functionally similar even though the buying mechanics differ.
Why tracking error matters
A well-run index fund should show a very small tracking error, meaning its returns closely mirror the target index rather than drifting away from it. A larger tracking error can point to higher costs, less efficient cash management, or execution issues inside the fund, and it is one of the more important things to check when comparing two index funds tracking the same underlying index.
How PriLytics helps. PriLytics lets you compare any fund's actual performance against its benchmark over any period, making tracking error, or its outperformance, directly visible in your own numbers. Compare against a benchmark.