Tracking Error in Index Funds: Causes & Impact 2023

Index Funds have started gaining immense popularity in recent times across the Indian investment markets, resulting in a number of index fund launches. These funds track different indices like the NIFTY 50, Sensex, NIFTY Next 50, NIFTY 100, etc. These schemes involve certain concepts such as tracking differences and tracking errors that is often not understood by investors.  

In this article, we will talk in detail about tracking error in Index Funds, why it occurs, some of its advantages/disadvantages, and what investors should do with regard to tracking error while investing in an Index Fund.

What is a tracking error?

Tracking error is the relative risk of an investment portfolio as compared to its benchmark index. It can be used to measure an investment’s performance, especially in comparing the performance against the benchmark over a specific period. Thus, tracking error is an indicator to understand how well a fund is being managed and the risks involved for investors.

In layman’s terms, tracking error is the difference between an investment portfolio’s returns and the index it mirrors. It is a handy measurement of the performance of portfolio managers. It is also known as an active risk for gauging the performance of hedge funds, ETFs, or mutual funds.

Let us understand this with the help of an example. Suppose an index has gained 4% in a month. If the index fund that tracks the index has gained 3.5% in the same month, then the monthly tracking error will be the difference, which is 0.5%. Even if the fund returns are 4.5%, the tracking error will be 0.5%.

Reasons for tracking error

There are 3 main reasons why a tracking error may occur in Index Funds. Here’s a look at each of these in detail: 

1. Mutual fund expenses

Mutual funds expenses could include the cost of buying and selling stocks, fund management fees, administration charges, etc which makes up the expense ratio of a mutual fund. The thumb rule is that the higher the expenses, the higher the tracking error. To limit the tracking error arising from higher expenses, fund managers often use many techniques like portfolio rebalancing, managing dividends, using Index Futures, lending securities, and fixed-income investments.   

2. Cash balance

Mutual funds usually don’t invest 100% of their assets. Most funds keep aside 2 to 5% of investable assets in cash or parked in highly liquid debt instruments for managing redemptions. 

An Index Fund may get an inflow of cash in case of a sudden rise in investment or dividend payouts through stocks within the portfolio. In such cases, a fund manager may take a while to reinvest additional money and this can result in an increase in tracking error. 

3. Inability to buy or sell underlying stocks

Tracking errors could also arise due to an index fund’s inability to buy or sell the underlying stocks. This could occur due to low liquidity levels or sudden market movements that trigger volatility in specific stocks. Such situations are often seen in sectoral or thematic funds that have larger tracking errors.

Importance of tracking error

Here are some of the pointers indicating the importance of tracking error –

• It helps in measuring and comparing a portfolio’s performance with the respective benchmark or index.
• Helps understand the consistency of higher returns.
• Portfolio managers can use tracking error for ascertaining how close a portfolio is to its benchmark.
• Using a tracking error, investors can determine how proficient a portfolio manager’s investment strategy is.

Limitations of tracking error

Investors must keep in mind the below-mentioned limitations of tracking error –

Tracking error can be used to measure both underperformance and outperformance of a fund against its benchmark. Investors often prefer a high tracking error in case of out-performance on the fund’s part. Alternatively, a low tracking error is preferable in case of consistent underperformance. However, tracking error cannot help in instantly distinguishing between the two.

Important points for investors

Investors can view tracking error as an indicator of how actively a fund is being managed and associated risk levels. Investors who observe the tracking error of a fund over a period to get sufficient insight into the risk control mechanisms implemented by the fund. 

• With the help of tracking error, investors can identify schemes which have avoidable risks like high levels of cash, imbalance in Index weightage, etc.

• While choosing an Index fund, it makes sense for investors to pick a fund with a low tracking error even if it is not the lowest among all investment categories.

• While it is important to look at tracking errors, it is also important to pay attention to the track record of the AMC and the fund. A smart way to select the right index fund is by selecting one that has a strong track record of operating with the lowest tracking error while charging the lowest expense to the fund.
  
  While tracking error results in the fund’s performance diverging from that of the index, the expense ratio is a fixed charge on the investment which will anyway chip off at the fund’s performance. Typically, AMCs managing large index funds with a longer track record offer the dual benefit of efficient tracking errors and relatively lower expense ratios.

Conclusion

Although rarely focused upon, tracking errors can have a significant effect on an investor’s returns. Therefore, it is important to consider this aspect of any index fund before investing in it.

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