All about Mutual Fund Tracking Error
The difference in returns between the index and mutual fund scheme
All mutual fund schemes have a benchmark index. Active funds aim to outperform the benchmark index and generate alpha for their investors. Passive funds aim to mirror the benchmark index and generate similar returns. However, the returns of passive funds are different (higher or lower) than the benchmark index. This difference in returns is the tracking error.
What is a tracking error?
- All index funds and exchange-traded funds (ETFs) mimic the performance of a benchmark index. They invest in all the benchmark index constituents in proportion to their weightage in the benchmark index.
- For example, a Nifty 50 index fund invests in all the 50 constituents of the Nifty 50 Index. The investment is made in all 50 stocks in the same proportion as per their weightage in the Nifty 50 Index. The fund will mimic the performance of the Nifty 50 Index and aim to generate similar returns. However, the fund returns, in most cases, are not similar to the index returns. This difference in returns between the benchmark index and index fund is known as tracking error.
- For example, assume that the Nifty 50 index delivers a 12% return, and the Nifty 50 index fund delivers an 11% return. The difference of 1% between the returns of the Nifty 50 index and the Nifty 50 index fund is known as the tracking error. In this case, the investor will read it as the Nifty 50 index fund has underperformed the Nifty 50 index by 1%.
- The tracking error measures the variation in performance between the passive fund and its benchmark index. It can also be used to evaluate the fund manager’s performance in terms of how well they manage the scheme.
Significance of tracking error
- The tracking error tells an investor how closely the passive fund is following or mimicking the benchmark index. A small tracking error means the fund is closely following the benchmark as per its objective. A large tracking error signifies that the fund is doing something different. Hence, the lower the tracking error, the better. If the tracking error of an index fund is higher than a specified limit, for example, higher than 2%, an investor should review their investment in the index fund.
- While comparing the performance of index funds mirroring the same index, ideally, investors should invest in the index fund with the lowest tracking error. For example, let us assume that you are comparing five index funds with the same benchmark, i.e. the Nifty 50 index. In this case, ideally, you should invest in the Nifty 50 index fund with the lowest tracking error.
Reasons for tracking error
Some of the reasons for tracking errors include:
- All mutual fund schemes have to incur certain expenses. These expenses include the scheme's daily running expenses, transaction fees for buying and selling securities, etc. These expenses are charged to the scheme as an expense ratio. So, the scheme will not be able to invest the entire money it has received from investors. As a result, the scheme's returns will be lower than the index, reflecting the tracking error. Hence, the lower the scheme expense ratio, the lower the tracking error.
- Every scheme maintains some money to meet redemption requests from investors. The money may be maintained in cash or other liquid assets. The dividend amount may not be re-invested in securities. Also, the scheme keeps receiving subscription money from investors. However, the money may not be invested in the index constituents.
- Due to all the above reasons, not all the scheme money is invested in index constituents at all times. As a result, the scheme returns are lower than the index returns, reflecting the tracking error. Hence, the scheme should maintain an optimum amount of cash to meet all redemption requests, and at the same time, the scheme returns are not compromised much.
- The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) rebalance the various indices from time to time. During the rebalancing, some securities are removed, and new ones are added to replace them. Whenever such a rebalancing happens, the index fund must rebalance its portfolio. However, there may be a time lag between the index rebalancing and the index fund rebalancing, leading to a variation in returns. The variation in returns reflects in the tracking error.
How to check the tracking error?
As an investor, you can check the tracking error of various mutual fund schemes on the AMFI website.
The above image shows that you can select the AMC name and the date, and you will get the tracking error for all the schemes of that AMC.
Measures for reducing tracking error
The fund manager can take the following steps to reduce the tracking error.
Investing in liquid debt securities instead of cash reserves
- Index funds maintain some money in cash reserves to meet redemption requests. Instead of keeping the money as cash in the bank account, the fund manager can invest this money in liquid debt securities. The money will earn returns till it is utilised.
- An index fund buys all the index securities. These securities can be used for lending under the stock lending scheme as per SEBI rules. Therefore, it will help the scheme earn some return rather than keeping the securities idle in the Demat account.
- The above measures can help the fund manager earn additional returns from the idle securities and cash in the bank account. In addition, the returns can reduce the scheme tracking error.
Choose the scheme with the lowest tracking error.
Most index funds will have some tracking error. However, you need to compare multiple schemes with the same benchmark and, ideally, choose the scheme with the lowest or one of the lowest tracking errors. Even after you invest in an index fund, you should evaluate the tracking error from time to time. For example, suppose the tracking error of your scheme has increased beyond a certain point while the tracking error of other similar schemes has gone down simultaneously. In that case, you may consider re-evaluating your scheme.
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