Investing and portfolio managementModule 3, lesson 11 of 24
Expense ratios and tracking error
What a fund's expense ratio covers, how small yearly costs compound over decades, and the difference between tracking difference and tracking error.
In this lesson
- Explain what a total expense ratio covers and how it is charged.
- Calculate the long-term effect of different expense ratios.
- Distinguish tracking difference from tracking error.
- Find and interpret costs and tracking measures in fund documents.
Builds on
- Index funds and ETFsTracking error applies to the index funds and ETFs explained there.
- Compounding and CAGRThe effect of costs grows through compounding.
On this page
In simple terms
Every fund has running costs: managing the money, administration, registrars, custodians and, for regular plans, distributor commissions. These are bundled into the total expense ratio (TER), expressed as a yearly percentage of the fund's assets.
The TER is deducted from the fund's value a little every day. You never pay a bill, so it is easy to ignore. That is exactly why it matters.
How costs compound
Worked example: Three made-up funds over 25 years
Suppose a fund's investments earn 11% a year before costs. You invest ₹10 lakh for 25 years.
| Expense ratio 0.2%: 10 lakh × 1.108^25 | about ₹1.30 crore |
|---|---|
| Expense ratio 1.0%: 10 lakh × 1.100^25 | about ₹1.08 crore |
| Expense ratio 1.8%: 10 lakh × 1.092^25 | about ₹0.90 crore |
The difference between 0.2% and 1.8% a year is about ₹40 lakh, roughly 30% of the cheaper fund's final value. The costs look tiny each year; compounded over decades they are large, as the compounding lesson explains.
For actively managed funds, the question is whether the manager adds enough return to justify a higher TER, which the active and passive lesson discusses. For index funds, which simply aim to match an index, lower costs are almost always better.
SEBI sets limits on how much funds may charge, and requires them to disclose their TER. The limits are set in regulations and change over time; the fund's factsheet and website show the current TER for each plan.
Tracking difference
An index fund aims to match its index, but it cannot do so exactly. Tracking difference is how far its return fell short of (or exceeded) the index's return over a period.
Worked example: A made-up index fund
Over a year, an index returned 12.4% (with dividends reinvested). An index fund tracking it returned 12.1%.
| Tracking difference: 12.4% − 12.1% | 0.3 percentage points |
|---|
Most of the gap usually comes from the expense ratio, with the rest from cash holdings, trading costs and timing.
Compare funds using the total-return version of the index, which includes dividends, otherwise the comparison is unfair to the fund.
Tracking error
Tracking error measures how much the gap between the fund and its index varies over time, usually as the standard deviation of the differences in returns. A fund can have a small average tracking difference but a large tracking error if it sometimes lags and sometimes leads by a lot.
For an index fund, both should be low:
- Low tracking difference means you keep most of the index's return.
- Low tracking error means the fund reliably does what it promises.
Funds publish tracking error in their factsheets.
Reading the documents
In a fund's factsheet or website, look for:
- the TER of both direct and regular plans;
- for index funds, tracking error and the returns of the fund compared with the index over several periods;
- the benchmark used, and whether returns are compared with its total-return version.
Why it matters
Costs are one of the few things investors can control, and one of the most reliable influences on long-term results. Choosing a fund with costs 1% lower is like earning 1% a year more, every year, with no extra risk. For index funds, tracking measures show whether you are getting what you are paying for.
Limitations
A low TER is not the only consideration: fund size, liquidity, the index tracked and the fund house's reliability also matter. Past tracking difference and error describe the past. Cost limits and disclosure rules are set by regulators and change.
Common mistakes
- Ignoring expense ratios because they look small.
- Comparing an index fund's return with the price-only index.
- Choosing a regular plan without comparing it with the direct plan.
- Assuming all index funds tracking one index cost the same.
Try it yourself
- Find three index funds tracking the same index.
- Note each one's TER and tracking error, and its return compared with the total-return index over one and three years.
- Calculate what ₹5 lakh would grow to over 20 years at 11% a year minus each fund's TER.
- Write down which you would choose and why.
Key takeaways
- The total expense ratio is the yearly cost of running a fund, as a percentage of its assets. It is deducted from the fund's value daily, so you never see a bill.
- Small differences compound. Over 25 years, a fund costing 1.8% a year can leave you with about 30% less than an identical one costing 0.2%.
- Tracking difference is how much an index fund's return falls short of its index over a period. Tracking error is how much that gap varies.
- For index funds, lower costs and lower tracking error are better, because the aim is simply to match the index.
- A 1% yearly fee is not small. Over a working life it can take a large share of the final value.
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Terms used in this lesson
- Expense ratio
- The yearly cost of running a fund as a percentage of its assets, deducted from its value a little every day.
- Tracking error
- How much an index fund's return varies around its index's return; tracking difference is the average gap between them.
- Index fund
- A fund that aims to match an index's return by holding the same shares in the same proportions, at low cost.
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This lesson is general education, not investment advice. Examples use made-up or clearly dated figures to explain ideas; they are not recommendations. Read the disclaimer.