Tracking Error Limits: How SEBI's Passive Funds Rules Keep Your Index Fund Honest

A passive fund makes one simple promise: it will mirror an index and charge you very little to do it. The trouble is that "mirror" is never perfect. A scheme tracking the Nifty 50 will always lag or lead the index by some margin because of cash held back for redemptions, the cost of rebalancing when the index changes, and the annual fee it deducts. To stop that gap from quietly growing, the Securities and Exchange Board of India (SEBI) issued its Development of Passive Funds circular, SEBI/HO/IMD/DOF2/P/CIR/2022/69, dated 23 May 2022, which capped tracking error and forced standardised disclosure across every index fund and exchange-traded fund (ETF) in the country.

This pulse compares the two ways Indian investors buy an index today, the index fund and the ETF, through the single lens that the 2022 circular put at the centre of the rulebook: how faithfully each one tracks its benchmark, and what that fidelity costs you after tax. If you are choosing a vehicle for a long-horizon passive allocation, the tracking number matters more than the marketing.

What Tracking Error Actually Measures

Tracking error is the standard deviation of the difference between a scheme's returns and its benchmark's returns. A low number means the fund hugs the index consistently day after day; a high number means it drifts. Under the 23 May 2022 SEBI circular, the annualised tracking error of index funds and ETFs that track non-debt indices, computed on the past one-year rolling data, should not exceed 2%. For schemes in existence for less than one year, the tracking error is computed since inception. If a fund breaches the 2% ceiling for reasons beyond its control, such as a corporate action, the asset management company (AMC) must disclose the breach on its website.

The circular pairs that ceiling with a transparency rule that is just as useful to investors. AMCs must disclose, on a monthly basis, both the annualised tracking error and the annualised tracking difference for periods of 1, 3, 5 and 10 years and since inception. Tracking difference is the plain gap between fund and benchmark returns over a window, which over time tends to settle near the fund's total expense ratio. You can read the formal definition in our tracking error glossary entry, and the cost driver behind it in the expense ratio entry.

One more design choice in the circular shapes everything below. Since SEBI mandated that fund performance be measured against the Total Return Index rather than the price index, the benchmark now includes reinvested dividends, which raised the bar a passive fund must clear. We unpacked that shift in our explainer on why funds switched to Total Return Index benchmarks, and it is the reason a 0.20% expense ratio shows up almost exactly as a 0.20% annual lag.

Side-by-Side Comparison

An index fund is a regular open-ended mutual fund that holds index constituents and is bought or sold at the end-of-day net asset value (NAV). An ETF holds the same basket but trades on the exchange through the day at a market price that can sit slightly above or below its underlying NAV. Both fall under the same 2% tracking-error ceiling from the 2022 circular, but their plumbing differs, and that plumbing is what separates their tracking records.

ETFs typically report lower tracking error than index funds because units are created and redeemed in-kind by authorised participants rather than the manager trading stocks to meet daily flows. An index fund must keep a cash buffer to honour redemptions, and that idle cash plus the trading it triggers is the classic source of cash drag that widens its gap against a Total Return benchmark. The trade-off is that an ETF investor pays brokerage and a bid-ask spread on every transaction, and in thinly traded ETFs the on-screen price can drift from NAV, so the structural advantage only holds where exchange liquidity is genuine.

That liquidity caveat is why SEBI built market-maker obligations and a stress-disclosure framework into the same passive-funds rulebook. The 2% ceiling protects you from a manager who tracks the index sloppily, but it does not protect an ETF buyer who crosses a wide spread on an illiquid counter. For a long-term lump-sum or systematic allocation, model both vehicles through our SIP calculator and lumpsum calculator and then check realised returns against the index with the XIRR calculator; the residual gap you cannot explain by fees is, in effect, your tracking cost.

Tracking Error vs Tracking Difference

These two numbers are easy to confuse and the 2022 circular deliberately requires both. Tracking error tells you about consistency, the wobble around the benchmark; tracking difference tells you about the level, how far behind you actually finished. A fund can have a tight tracking error of 0.30% yet a tracking difference of negative 0.50% a year if its costs are high but steady. The table below sets out the distinction.

For a long-term passive investor, the tracking difference over 5 and 10 years is arguably the more important figure, because it compounds. A persistent annual drag of 0.50% versus 0.10% sounds trivial, but over a 20-year SIP the cheaper, tighter tracker can leave you materially ahead. The expense ratio is the largest controllable lever here, and we showed how those slabs erode returns in our piece on how SEBI's TER slabs shrink fund returns. Always compare two funds that track the same index on both numbers, sourced from AMC disclosures aggregated by the Association of Mutual Funds in India (AMFI).

Tax Treatment

Here the two vehicles converge completely, which simplifies the decision. When an index fund or an ETF holds at least 65% of its assets in domestic equity, it is an equity-oriented scheme, and equity-oriented schemes are taxed identically regardless of whether you bought the index fund or the ETF version of the same benchmark. The rates below reflect Budget 2024, which revised capital gains with effect from 23 July 2024 under Sections 111A and 112A of the Income Tax Act.

The Rs 1,25,000 long-term exemption is an annual aggregate across all your equity LTCG, so it is not multiplied by holding both an index fund and an ETF. A short-term gain on an equity index product is taxed at 20% under Section 111A from 23 July 2024, up from the earlier 15%, while the long-term rate moved to 12.5% from the earlier 10%. The 4% health and education cess applies on top of the computed tax in every case.

A critical caveat: not every index fund is equity-oriented. A fund tracking an overseas index or a bond index does not meet the 65% domestic-equity test, so it is taxed as a non-equity scheme, where gains are added to your income and taxed at your slab rate with no Section 112A concessional rate. Confirm the asset allocation in the scheme information document before assuming the 12.5% rate applies; the tracking-error rules of the 2022 circular cover these funds too, but their tax outcome is entirely different. The definitions of long-term capital gains and short-term capital gains in our glossary spell out the holding-period tests.

Who Should Pick Which

The choice is less about which product is "better" and more about how you transact and what infrastructure you already use. Because both share the same 2% tracking-error ceiling and identical equity taxation, the deciding factors are your access, your transaction pattern and your tolerance for the bid-ask spread.

Choose an index fund if you invest through monthly systematic plans, do not hold a demat account, or want to automate small contributions of Rs 500 or Rs 1,000 without watching live prices. The end-of-day NAV transaction removes any risk of buying at a premium to NAV, and the cost of slightly higher tracking error is usually smaller than the spread an occasional ETF buyer would pay. For most retail SIP investors building a long-horizon corpus, the index fund is the lower-friction route, and you can size the plan with the SIP calculator.

Choose an ETF if you have a demat account, transact in lump sums, value the lower structural tracking error, and are disciplined enough to trade only when on-screen liquidity is deep and the price sits close to NAV. ETFs suit investors deploying larger one-time amounts where the brokerage and spread are a tiny fraction of the trade, and where the in-kind mechanism's tighter tracking compounds in their favour over a 10-year horizon. If you are weighing a tax-saving equity allocation alongside a pure index holding, compare the lock-in and return profile using the ELSS calculator and validate post-purchase tracking with the mutual fund returns calculator. Whichever you pick, the 2022 circular guarantees you can audit the manager on a single, comparable number: tracking error against the benchmark, capped at 2% and disclosed every month.

FAQ

What is the maximum tracking error a SEBI index fund can have?

Under SEBI Circular SEBI/HO/IMD/DOF2/P/CIR/2022/69 dated 23 May 2022, the annualised tracking error of index funds and ETFs that track non-debt indices, computed on past one-year rolling data, should not exceed 2%. Schemes that breach 2% for reasons beyond their control must disclose the fact on the AMC website.

Is tracking error the same as tracking difference?

No. Tracking error is the standard deviation of the daily return difference between the scheme and its benchmark, so it measures consistency. Tracking difference is the simple gap between scheme and benchmark returns over a period (1, 3, 5 and 10 years and since inception), which SEBI requires AMCs to disclose monthly. A fund can have low tracking error yet a persistent negative tracking difference equal to its expense ratio.

Do index funds and ETFs that track the same index get taxed differently?

No. Both are equity-oriented schemes when they hold at least 65% in domestic equity, so both attract 12.5% long-term capital gains tax above the Rs 1,25,000 annual exemption (holding over 12 months) and 20% short-term tax (holding up to 12 months), as set by Budget 2024 with effect from 23 July 2024 under Sections 112A and 111A.

Why do ETFs usually report lower tracking error than index funds?

ETFs use an in-kind creation and redemption mechanism through authorised participants, so the fund manager is not forced to buy or sell index stocks to meet daily investor flows. Index funds hold a small cash buffer and trade in the cash market to manage subscriptions and redemptions, which adds cash drag and turnover cost that widen tracking error against the benchmark.

Where can I check a fund's tracking error before investing?

The 23 May 2022 SEBI circular requires AMCs to disclose tracking error and annualised tracking difference for 1, 3, 5 and 10 years and since inception on their websites and in scheme documents, updated monthly. AMFI also aggregates scheme-level disclosures, so compare two funds tracking the same index on both tracking error and total expense ratio before deciding.

Does a higher expense ratio always mean higher tracking error?

Not always, but the expense ratio is the single largest structural drag. A fund charging 0.20% will, all else equal, trail its total-return benchmark by roughly 0.20% a year as tracking difference. Cash drag, rebalancing costs and securities-lending income also move the number, which is why two funds tracking the same index can show different tracking error despite similar fees.