Ace the NISM Mutual Fund Distributors ExamDifficulty: BeginnerInfo   5 min read
📌 Chapter 11.8 — Tracking Error

Consider a client who has been tracking two large-cap funds for their long-term equity portfolio. Both funds demonstrate similar tracking errors relative to the Nifty 50, but one fund has consistently generated higher returns than the other. A novice distributor might mistakenly conclude that the fund with the higher returns is objectively better, failing to account for the risk taken to earn that surplus. This is where the Information Ratio becomes an essential tool for an MFD to differentiate between genuine skill and blind luck.

The Information Ratio is calculated by dividing the excess return of a scheme over its benchmark by the tracking error. Think of it as a measure of efficiency; it tells you how much additional return the fund manager is squeezing out for every unit of deviation from the benchmark index. While tracking error tells you how much the fund deviates, the Information Ratio tells you if that deviation was worth the trouble. It effectively captures the consistency of the manager’s “active calls” versus the cost of straying from the benchmark.

For an MFD, this distinction is vital when performing suitability assessments for clients who are sensitive to volatility. Suppose you are comparing two flexi-cap funds in the Indian market. Fund A has a low tracking error but provides very little alpha, while Fund B has a slightly higher tracking error but a significantly higher Information Ratio.

In this case, Fund B indicates that the manager’s active bets are consistently adding value, making it a potentially superior choice for a client seeking growth. By incorporating this ratio into your quarterly portfolio reviews, you transition from simply reporting returns to providing high-value diagnostic insights.

Always remember that while direct plans offer lower expense ratios, your value as an MFD lies in filtering through these metrics to select schemes that align with the client’s risk appetite. A client may be tempted by a fund’s raw performance, but your role is to explain that high returns without a solid Information Ratio often imply excessive, uncompensated risk. Helping a client understand that they are paying for your expertise to identify consistent managers, rather than just market-beta chasers, builds deep trust and long-term retention.

Nuance

⚠️ Nuance
A common pitfall is the belief that a high Information Ratio automatically justifies a fund regardless of its absolute performance. Candidates often forget that if a fund’s tracking error is extremely low, the ratio can become artificially inflated, potentially giving a false sense of security. Always examine both the absolute alpha and the ratio together, as a manager might be “hugging the benchmark” to keep tracking error low while barely outperforming.

Check Your Understanding

Practice Question 1

An MFD is evaluating two mutual fund schemes. Fund X has an active return of 2% and a tracking error of 1%. Fund Y has an active return of 4% and a tracking error of 3%. Based on the Information Ratio, which fund is more efficient?

Practice Question 2

In the context of the NISM-Series-V-A exam, what is the primary role of the Information Ratio for a mutual fund distributor?

This is a companion read for Section 11.8 — Tracking Error from Ace the NISM Mutual Fund Distributors Exam by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 Akhilesh Gururani. All rights reserved.