Most of us believe that index funds will consistently deliver returns similar to the market, regardless of whether we invest in SIPs or a lump sum. Now imagine this: one person invests Rs 5 lakh as a lump sum, and another invests Rs 10,000 every month in the same index fund’s SIP. Both believe their money will grow in line with the index. But after a few years, the SIP investor is surprised to see his corpus trailing the index by a big margin — while the lump-sum investor hardly feels any gap at all.
So, what can be the reason behind the SIP trailing the index? The root cause of this variance is in tracking error. Let’s understand in detail.
What is a tracking error?
Tracking error is simply the gap between the index’s return and the fund’s return. An index fund is supposed to track the index as closely as possible. But when the fund starts delivering returns that are consistently above or below the index, that gap is called tracking error.
A small gap is normal. But when this gap keeps widening, the fund stops behaving like the index — and that’s where the real damage begins.
Why are SIP investors more affected?
A lump-sum investor puts in money just once, so the tracking error may hurt his investment only at that point. But a SIP investor is buying new units every month. This means the impact of tracking error hits him again and again. Over time, this small monthly gap keeps adding up — and eventually turns into a meaningful loss.
Recurring losses: Why the impact increases in SIPs
Tracking error isn’t always constant — sometimes it can be very negligible like around 0.1 to 0.2%. For example, for large-cap index funds, the 1-year tracking error is seen around 0.20% or lower; for small-cap index funds, it might be a bit higher (0.30-0.40%).
For a lump-sum investor, this gap affects returns only once. But in a SIP, the same gap keeps repeating itself until the investment continues. That sustained impact is what quietly eats into long-term returns.
In simple terms — a tracking error in SIPs is like a small cut that becomes a significant injury in the long run.
Behaviour impact: Losses are realised only at the end
Most SIP investors don’t even notice tracking errors. They assume index funds always perform like the index.
The SIP continues for many years, and only when the corpus finally seems significantly smaller than the index do they realize where the losses occurred—but by then it’s too late.
A simple example: How the difference translates into big losses
Let’s say the index returned 12%, but a fund with a high tracking error only returned 11.5% – a loss of 0.5%.
For a lump-sum investor, this difference is a one-time setback.
But for a SIP investor, every installment is affected by this difference for 10–15 years.
The result?
For lump sum investors-
Lump sum investment in an index fund: Rs 1 lakh
Investment duration: 15 years
Rate of return: 12% annualised
Total corpus after 15 years: Rs 5.47 lakh
With tracking error: 0.5% (assumed a bit higher to show a corpus difference)
Total corpus after adjusting 0.5% tracking error: around 5.12 lakh
So, the tracking error causes a loss of Rs 35,000 for this lump sum investor over 15 years.
Now, see the tracking error’s impact on SIP investment over 15 years.
Monthly SIP in the fund: Rs 10,000
Rate of return on SIP: 12% annualised
Total corpus after 15 years: Rs 50.45 lakh
Now, what’s the SIP corpus after adjustment of tracking error (0.5%)
Total corpus after factoring in tracking error: Rs 48.1 lakh
So, in this example, the loss becomes larger, resulting in a reduced corpus of Rs 2.44 lakh over 15 years. This figure is only an assumption, of course — the final corpus can change further because tracking error itself keeps fluctuating over time. But this illustration serves one purpose: to show that SIP investors face a much bigger cumulative impact of tracking error compared to lump-sum investors.
So, you saw how tracking error eats into profitability and cut your final corpus by lakhs of rupees over the long-term.
Tracking error especially becomes a hidden compounding killer in long-term SIPs.
Why does tracking error increase?
Tracking error doesn’t rise out of nowhere — it increases due to a few common issues. Index funds are required to keep some cash on hand, and higher expense ratios naturally drag returns down. Sometimes the fund manager may not be able to rebalance the portfolio as quickly as the index does, or may not match corporate actions like bonuses and stock splits on time. In some cases, the fund becomes too large or grows too rapidly, making it harder to replicate the index exactly. When these small gaps add up, the fund stops mirroring the index perfectly — and the tracking error begins to rise.
Takeaway: Tracking error is a big factor for SIP investors.
SIP investors invest money every month, so tracking error has a “monthly impact” on every investment.
For them, tracking error isn’t just a technical term — it’s a hidden damage that occurs every month.
If it’s high, it impacts your entire wealth journey.
What should SIP investors do?
If you’re doing a SIP, remember these things:
1. Be sure to check the 1-year and 3-year tracking error.
2. Choose funds with a low tracking error (around or lower than 0.5%).
3. Avoid funds with a high fluctuation in tracking error.
4. Check the AMC’s historical index replication record.
Disclaimer: The above content is for informational purposes only. Mutual Fund investments are subject to market risks. Please consult your financial advisor before investing.
