ETFs in India Explained - Understanding Tracking Error and Expense Ratio

Introduction

With the rise in passive investing, Exchange Traded Funds (ETFs) have emerged as a popular investment vehicle in India. This post breaks down what ETFs are, how they differ from mutual funds, and why tracking error and expense ratios are crucial for investors. We also share insights from an analysis of the latest ETF data.

ETFs (Exchange-traded funds) typically aim to replicate the performance of a specific index (e.g., Nifty 50, Nifty Bank) by holding a basket of securities in the same proportion as the underlying index, but doing this perfectly is not always possible in real-world conditions. This gives rise to something called tracking error.

Tracking error & Expense ratio

Tracking error is the difference between the ETF's returns and its benchmark index's returns. It happens due to factors like fund management practices, timing of trades, dividend reinvestment delays, and even transaction costs. Ideally, a good ETF should have a low tracking error, meaning it’s closely following its benchmark. Now, just like mutual funds, ETFs also charge a fee to manage your money, called the expense ratio.

But here’s the good news: ETF expense ratios are usually much lower than those of actively managed mutual funds because ETFs follow a passive investment strategy (they’re just copying an index, not trying to beat it). Lower costs make ETFs an attractive option for long-term investors seeking market-linked returns at minimal cost.

Methodology

To analyse the tracking error and expense ratio of Indian ETFs, we began by downloading the most recent dataset of all 245 listed ETFs from the NSE website. First, we removed ETFs that track global indices such as the NASDAQ, S&P 500, Hang Seng, and other international indexes and excluded commodity ETFs like those tracking gold or silver, as our focus was on domestic ETFs. Next, we filtered out ETFs with low liquidity, defined as those having an average daily trading volume of less than 50,000 units. This ensured we focused on actively traded ETFs relevant to retail investors.

To ensure the robustness of our dataset, we cross-verified the filtered list with external sources like AdvisorKhoj's ETF Corner. For the final list 92 of ETFs, we gathered tracking error data from AMFI's tracking error database, using data for Direct Plans wherever available. Similarly, expense ratio data was sourced from AMFI's TER portal, again prioritizing Direct Plan data. When direct Plan data was unavailable, we used figures from the Regular Plans.

Final list of ETFs Data - ETF.xlsx

Key Insights from the ETF Data –

1. The average tracking error was just 0.11%, indicating that most ETFs follow their benchmark indices closely.

2. The average expense ratio for the final list of ETFs is just 0.24%, significantly lower than traditional mutual funds, where expense ratios often range between 1% to 2%.

3. The lowest tracking error found was as little as 0.01%, while the maximum tracking error observed was 1.15%, suggesting that even the least efficient ETFs only marginally diverge from their benchmarks.

4. Even the maximum expense ratio observed is 0.50%, which still falls on the lower end compared to actively managed funds.