12.7 Tracking Error and Scheme Performance Disclosure

NISM-Series-V-A: Mutual Fund Distributors Certification Examination Exam

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1 Chapter 1: Introduction & Exam Overview

1.1 About the NISM-Series-V-A Examination 1.2 The 12-Unit Curriculum Map and a Study Plan

2 Chapter 2: Investment Landscape

2.1 Investors and Their Financial Goals 2.2 Savings or Investments? 2.3 Different Asset Classes 2.4 Investment Risks 2.5 Risk Measures and Management Strategies 2.6 Behavioural Biases in Investment Decision Making 2.7 Risk Profiling 2.8 Asset Allocation and Do-It-Yourself versus Professional Help

3 Chapter 3: Concept and Role of a Mutual Fund

3.1 Concept of a Mutual Fund 3.2 Classification of Mutual Funds 3.3 Growth of the Mutual Fund Industry in India

4 Chapter 4: Legal Structure of Mutual Funds in India

4.1 Structure of Mutual Funds in India 4.2 Key Constituents of a Mutual Fund 4.3 AMC Organisation Structure and Service Providers 4.4 Role and Function of AMFI

5 Chapter 5: Legal and Regulatory Framework

5.1 Role of Regulators in India 5.2 Role of SEBI and the Mutual Fund Regulations 5.3 Due Diligence Process by AMCs for Distributors 5.4 Investor Grievance Redress Mechanism 5.5 AMFI Code of Conduct for Intermediaries

6 Chapter 6: Scheme Related Information

6.1 Mandatory Documents I: Scheme Information Document and Statement of Additional Information 6.2 Mandatory Documents II: Key Information Memorandum and the Advertisement Code 6.3 Non-Mandatory Disclosures

7 Chapter 7: Fund Distribution and Channel Management Practices

7.1 The Role and Importance of Mutual Fund Distributors 7.2 Different Kinds of Mutual Fund Distributors 7.3 Modes of Distribution 7.4 Pre-requisites to Become a Distributor of a Mutual Fund 7.5 Revenue for a Mutual Fund Distributor 7.6 Commission Disclosure Mandated by SEBI 7.7 Distributors versus Investment Advisers, Nomination Facilities and Change of Distributor

8 Chapter 8: Net Asset Value, Total Expense Ratio and Pricing of Units

8.1 Fair Valuation Principles 8.2 Computation of Net Assets of a Scheme and NAV 8.3 Dividends and Distributable Reserves 8.4 Entry and Exit Load and Its Impact on NAV 8.5 The Expense Ratio Framework: Base Expense Ratio, Brokerage and Statutory Levies 8.6 Key Accounting and Reporting Requirements 8.7 NAV, Total Expense Ratio and Pricing of Units for the Segregated Portfolio

9 Chapter 9: Taxation

9.1 Applicability of Taxes in Respect of Mutual Funds 9.2 Capital Gains on Mutual Fund Units 9.3 Dividend (IDCW) Income and Tax Deducted at Source 9.4 Stamp Duty and Securities Transaction Tax on Mutual Fund Units 9.5 Setting Off Capital Gains and Losses under the Income Tax Act 9.6 Tax Benefit under Section 80C and Applicability of GST

10 Chapter 10: Investor Services

10.1 The New Fund Offer Process 10.2 New Fund Offer Price and Ongoing Offer Price for Subscription 10.3 Investment Plans and Services 10.4 Allotment of Units and Account Statements 10.5 Mutual Fund Investors: Who Can Invest 10.6 Filling the Application Form for Mutual Funds 10.7 Financial Transactions with Mutual Funds 10.8 Cut-Off Time and Time Stamping 10.9 KYC Requirements for Mutual Fund Investors 10.10 Systematic Transactions and Their Operational Aspects 10.11 Non-Financial Transactions, Special Investor Categories and Turnaround Times

11 Chapter 11: Risk, Return and Performance of Funds

11.1 General and Specific Risk Factors 11.2 Factors That Affect Mutual Fund Performance 11.3 Drivers of Returns and Risk in a Scheme 11.4 Measures of Returns 11.5 SEBI Norms Regarding Representation of Returns 11.6 Risks in Fund Investing: The Investor's Perspective 11.7 Measures of Risk and Provisions Relating to Credit Risk

12 Chapter 12: Mutual Fund Scheme Performance

12.1 Benchmarks and Performance 12.2 Price Return Index or Total Return Index 12.3 Basis of Choosing an Appropriate Performance Benchmark 12.4 Benchmarks for Equity Schemes 12.5 Benchmarks for Debt Schemes and Other Schemes 12.6 Quantitative Measures of Fund Manager Performance 12.7 Tracking Error and Scheme Performance Disclosure

13 Chapter 13: Mutual Fund Scheme Selection

13.1 Scheme Selection Based on Investor Needs, Preference and Risk Profile 13.2 Risk Levels in Mutual Fund Schemes 13.3 Scheme Selection Based on Investment Strategy 13.4 Selecting a Scheme Across AMCs or Within a Scheme Category 13.5 Selecting Options in Mutual Fund Schemes and Do's and Don'ts

12.7 Tracking Error and Scheme Performance Disclosure

Key Takeaways Explain This Topic AI

Tracking error is the standard deviation of the difference between scheme and benchmark returns.

Tracking difference is the simple return gap, while tracking error measures its variability.

Low tracking error is the objective for a passive scheme, not outperformance.

Tracking error arises from expenses, cash holdings, rebalancing costs and dividend timing.

AMCs must disclose scheme performance in prescribed formats, including all schemes managed by a fund manager.

Last updated: August 2026

Tracking Error

Tracking error is the standard deviation of the difference between a scheme's returns and its benchmark's returns over a period. It measures how consistently the scheme follows the index, not how far behind it is.

A closely related but distinct measure:

• Measure Definition
• Tracking difference The simple gap between scheme return and benchmark return
• Tracking error The standard deviation of that gap over time

A fund that trails its index by exactly 0.35% every single month has a large tracking difference and a very small tracking error , because the gap is entirely predictable. A fund whose gap swings between +2% and -2% has a small average difference and a large tracking error. For a passive investor the second is far worse , because the scheme is not reliably delivering the index.

Why Tracking Error Exists

Even a perfectly managed index fund cannot match its index exactly:

• Source Effect
• Expense ratio The scheme bears costs; the index bears none
• Cash holdings Cash for redemptions is not invested in the index
• Rebalancing costs Brokerage, impact cost and levies when the index changes
• Dividend timing The index assumes immediate reinvestment; the scheme reinvests with a lag
• Inflows and outflows Deployment and liquidation occur at prices that differ from index levels
• Sampling Some funds hold a representative subset rather than every constituent

Because the expense ratio is a permanent drag, a passive scheme is expected to return slightly less than its total return benchmark , and the size of that shortfall is the measure of how well the scheme is run.

Evaluating a Passive Scheme

The criteria differ fundamentally from those for an active scheme:

• Active scheme Passive scheme
• Objective Beat the benchmark Match the benchmark
• Success measure Alpha, information ratio Low tracking error , low tracking difference
• Expense ratio Weighed against alpha Should be as low as possible
• Manager skill Central Largely irrelevant; execution quality matters
• Outperformance Desirable A warning sign of unintended deviation

That final row is counter-intuitive and examinable: an index fund that beats its index has deviated from it, which means it is not doing its job. The investor bought the index and received something else.

When comparing two index funds tracking the same index, the ranking is straightforward: lower expense ratio and lower tracking error . There is very little else to distinguish them.

Tracking Error in Active Schemes

Tracking error also applies to active schemes, where it measures active risk — how far the manager departs from the benchmark.

Very low tracking error in an actively managed scheme suggests a closet index fund: the investor pays active fees for near-index exposure.

Very high tracking error indicates aggressive deviation, which may or may not be rewarded.

The information ratio — excess return divided by tracking error — assesses whether the deviation earned its keep.

Scheme Performance Disclosure

SEBI prescribes how performance must be published, so that the record is complete and comparable.

Content requirements:

• Performance for the prescribed periods , commonly one, three and five years and since inception
• Benchmark returns for the identical periods, on a Total Return Index basis
• Absolute returns for periods of less than one year; compounded annualised returns thereafter
• Point-to-point returns on a standard investment amount
• The caution that past performance may or may not be sustained

Completeness requirements:

Performance of all schemes managed by the same fund manager must be disclosed, so an investor sees the manager's full record rather than only the strongest scheme

Performance of all schemes of the AMC , in the prescribed format on the website

Disclosure requirements prevent selective survivorship , so discontinued or merged schemes cannot simply vanish from the presented record

Where the benchmark or fundamental attributes changed , the presentation must make that visible

Where it is published:

• The AMC website, in the prescribed format
• Fact sheets and scheme documents
• Advertisements, subject to the advertisement code
• The Fund Manager Disclosure Is the Useful One

Of all these requirements, the obligation to disclose every scheme managed by the same fund manager is the one a distributor should actually use. A manager presented as outstanding on the strength of one scheme may run four others that have lagged. The disclosure makes the full record visible, and checking it takes a minute.

What to Check When Reviewing Performance

Is the comparison against the prescribed Tier 1 benchmark , on a TRI basis?

Are the periods the prescribed ones, or a window that flatters?

Has the benchmark changed during the period shown?

For a passive scheme, what are the tracking error and tracking difference ?

For an active scheme, what is the information ratio , and is tracking error so low that it is effectively an index fund?

What is the fund manager's record across all schemes managed?