Understanding Index Fund Tracking Error: Causes & Implications

Index fund tracking error is a problem that you will have to consider if you plan on investing in index funds. Index fund tracking error could occur as a result of a number of different circumstances. Here are a few potential causes of index fund tracking error.

Asset Allocation

One possible cause of index funds tracking error is the wrong mix of asset allocation by the fund manager. For example, in relation to the total assets of the fund, the fund manager might keep too much cash. This could result in slight differences from the performance of the index to the performance of the index fund.

Inefficiency

Another reason that an index fund may not be able to identically track an index is because of inefficiency in buying and selling stocks. For example, when certain companies are removed from an index and other companies added, this results in the index fund having to buy shares of the companies that were added and sell off the shares from the companies that were removed. When this happens, the rest of the market knows exactly what the index fund has to do. This can affect the stock prices of the securities and lower the overall returns of the index fund.