Understanding Tracking Error

Investing in mutual funds, index funds, and ETFs has grown increasingly popular in India, as more investors seek to grow their wealth. The amount invested in mutual funds exceeds crores, while the growth of index funds and ETFs has been tremendous. However, many investors don’t know about an important factor affecting their returns over time: tracking errors. These are small differences between the fund’s performance and the index it follows, but they can add up.

Let’s understand tracking error, what it means, and how to reduce its impact on your finances.

Meaning of Tracking Error

Tracking error is the difference between how much a fund, like an index fund or ETF, earns compared to its benchmark index. It shows how closely the fund follows the index. For example, if the Nifty 50 returns 12% for a year, and your Nifty 50 index fund gives 11.6%, the tracking error will be considered 0.4%.

Formula to calculate tracking error:

Tracking Error = Standard Deviation of (Fund Return - Index Return)

It is usually expressed as a percentage and calculated using daily or weekly return data.

Why does Tracking Error occur?

A fund manager may not be able to replicate the index perfectly because of several practical constraints, and here are some of them:

• Expense Ratio: Index funds and ETFs have a slight cost for managing your money, which, among other things, goes to reducing returns and causing tracking errors.
• Cash Drag: Sometimes, a part of the fund’s money stays in cash instead of being fully invested. This can stop the fund from matching the index’s returns.
• Index Rebalancing Delays: Indices change composition, and if the timing for replicating these changes by the fund lags, it gives a temporary mismatch.
• Dividend Treatment: Some indices generate total returns by reinvesting dividends, but the fund does not quite match it.
• Regulatory or Operational Constraints: Rules restricting foreign investment limits or trading holidays could impede a fund from purchasing certain stocks promptly.

Understanding with example

Here’s a real-world example of a tracking error to show how it works:

Both funds have lagged behind their respective benchmarks. While this is normal to a certain extent, a low tracking error (below 0.5%) should be preferred since it indicates a fund's capability to deliver index-like returns with more reliability.

How much Tracking Error is acceptable?

Investors should aim for funds with consistently low tracking errors. Below are the percentages of different levels of tracking errors:

When should you check Tracking Error?

Here are some ideal times to evaluate a fund's tracking error:

• Before Investing: Examine various funds tracking an index and select the one with the least tracking error at the 1-year and 3-year intervals.
• After Market Events: Some big market-moving events, such as elections, budget announcements, or monetary policy changes, also affect tracking accuracy.
• During Portfolio Review: While undertaking an assessment every six months or once a year, look at the tracking error with the fund returns.

How to reduce the impact?

Here's what you can do to reduce tracking error on investments:

• Choose Direct Plans: Lower expense ratios lead to lower tracking error, which direct plans tend to have compared to regular ones.
• Check AUM (Assets Under Management): AUMs generally do better when they rebalance their portfolios and run efficiently.
• Look at Tracking Error History: Always check the 1-year and 3-year historical tracking error ranges. Inconsistency is more important than just the occasional spike.

Common misconceptions

Below are some of the myths compared to reality on tracking errors, which are always involved when managing finances:

Conclusion

Knowing the meaning of tracking error goes a long way in selecting a better passive fund. It is a silent, nasty measure of fund efficiency. While looking at index funds or ETFs, don't just go by what returns the fund generates; check returns against the benchmark. Use platforms that display returns, expense ratios, and tracking errors in one place for better comparison.