If you are planning to invest in passive funds, and index funds in general, you should be well aware of the concerned fund’s tracking error. In fact, tracking error of a mutual fund is as important as the fund’s historical performance. Read on to know what is tracking error is and the impact it could have on the returns of your mutual fund investment.
Tracking error is a measurement of a mutual fund’s financial performance against its benchmark over a period of time. It is calculated as the annualised standard deviation of the tracking difference in a certain period. In other words, you can check a fund’s tracking error to see how closely its portfolio follows the benchmark.
Fund managers of active funds can show a large tracking record as they try to get excess returns through active positioning. In contrast, passively managed funds aim to keep the tracking error as low as possible.
An index fund with a low tracking error shows that it is closely following the benchmark. It can indicate which funds are being more actively managed and their risk levels.
You should avoid index funds with a large tracking error as it indicates that there is something significantly wrong with the investment. This could indicate that a fund is taking unnecessary levels of risk like holding large amounts of cash or maintaining lopsided weightage. Always remember that most of the best index funds come with a low tracking error.
Tracking error could be calculated through two methods. In the first method, the cumulative returns of the index is deducted from the portfolio’s returns. The tracking error formula would be:
Tracking Error = P – I, where P stands for portfolio returns and I stands for index or benchmark.
The second method would be to deduct portfolio returns from the benchmark or index and then the standard deviation of the outcome would be calculated with the following formula:
Tracking Error = P – B, where P stands for portfolio returns and B stands for benchmark returns. Let’s understand this with an example.
For example, if the underlying index has delivered a return of 5% over one year, whereas the index fund has given a return of 4.9% over the same period, the tracking error of the index fund would be 0.1%.
So, as an investor, should you be concerned about tracking errors? Yes, of course!
Continuing with the above example, a tracking error of 0.1% indicates that you would be earning 0.1% less than what you would make if you had directly invested in the underlying index.
However, if the index fund replicates the underlying benchmark, why should there be a tracking difference?
The probable reasons for tracking error could be as follows:
An index fund will not be able to invest 100% of the corpus in the index constituents. It has to maintain certain cash to meet redemption requests, day-to-day fund management charges, transaction costs, etc.
Corporate actions such as dividends, bonuses, mergers, rights, preferential issues, etc., require the fund to re-align with the index’s composition. The scheme would require buying and selling portfolio components that add up to the transaction cost, affecting the returns of the fund.
Sometimes, the underlying index may have new entrants or exits. To maintain the same composition as the underlying index, the index fund must purchase or sell those securities. However, there could be a mismatch in the price, circuit filters, etc., that may create a mismatch in quantities and eventually the returns.
The following are the best index funds according to their tracking error:
|Name of the Index Fund||Tracking Error|
|Navi Nifty 50 Index Fund||0.04%|
|HDFC Index Fund- Sensex Plan||0.06%|
|SBI Nifty Index Fund||0.10%|
|HDFC Index Fund- Nifty 50 Plan||0.10%|
|UTI Nifty Index Fund||0.11%|
|Nippon India Index Fund- Sensex Plan||0.12%|
|DSP Nifty 50 Index Fund||0.13%|
|ICICI Prudential Nifty Next 50 Index Fund||0.13%|
*Note that the table is for educational purposes only.
Disclaimer: Mutual Fund investments are subject to market risks. Read all scheme related documents carefully before investing.
Tracking error helps measure the performance of a portfolio against its underlying index. An index fund with a low tracking error has a minimum deviation in terms of returns from the benchmark index.
You must check the tracking error of index funds rather than fund returns. It helps to pick an index fund with a lower tracking error to minimise the deviation in return from the benchmark index. Tracking error also helps you measure the consistency of excessive returns.
If passive funds are your go-to investment avenue, try to invest in funds with low tracking error. It also aids to gauge the performance of a particular fund against its concerned benchmark over a particular period of time.
In case you are looking to invest in funds that could give you market-level returns, try Navi Mutual Fund. With Navi’s mutual funds, you could explore a wide range of low-cost index funds, including the Navi Nifty 50 – a fund that comes with a significantly low tracking error.
Ans: A smaller number usually indicates better portfolio earnings against the index benchmark. However, determining whether a tracking error is good or bad entirely depends on the objective of the investment.
Ans: Often, active portfolio managers show high tracking error because they try to achieve excess return against the benchmark. On the contrary, passive fund managers seek low tracking error with return deviations coming from trading and liquidity costs, imprecise cash flows, tax costs, etc.
Ans: Tracking error helps portfolio managers understand how close they are to the benchmark.
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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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