What is the tracking error in mutual funds

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Index funds are becoming a preferred option for many investors due to their low cost structure and uneven track record of active funds to consistently generate alpha.

While index funds mimic the portfolio of an underlying index, the returns generated by index funds deviate from that of the latter for a variety of reasons. Tracking error, which measures the extent to which the fund is generating returns relative to the returns of the target index, is one of the most important measures of risk in evaluating the performance of index funds. Understanding how to read and compare the tracking error helps investors choose a better index fund.

What is that

Index funds, like other MF systems, have expenses. These fees are charged as an expense ratio to the investor and thus reduce the returns of the plan relative to the index. In addition, securities transactions, the plan’s cash balance and changes in the underlying index may also impact the performance of the plan relative to the benchmark.

The difference between the performance of the index product and that of its benchmark on a particular date is called the tracking difference. For example, the replication spread of two index funds following Nifty 50 – HDFC Index Fund – Nifty 50 Plan and ICICI Pru Nifty Index Fund, as of September 30, 2021, for the last period of one year is almost the same at 1, 06 percentage point.

Tracking error, which is usually confused with tracking difference, indicates the variability in system performance over a period of time. It is calculated by annualizing the standard deviation of the difference in return between the index fund and its target index. Take the example above; Although the two funds have a similar tracking difference as of September 30, 2021, the tracking error during said period for HDFC is less than 0.03% compared to 0.06% for ICICI.

The lower the tracking error, the smaller the divergence of the fund’s returns from that of the target index during that time period.

Asset management companies (AMS) use a variety of methods to reduce tracking error. For example, when the fund’s cash balance is high, it would be temporarily invested in solutions such as fixed income, index futures, etc. for a short period until a reinvestment. is carried out in the actions.

Not comparable

Index funds aim to mimic the portfolio but hardly can exactly mimic returns. Indexing simply ensures that the returns of the fund will not deviate significantly from the returns of the index. A lower tracking error indicates that the fund company was efficient in managing the funds.

Thus, it is important to check and compare the tracking error of different funds before investing.

However, a review of the methodology for calculating tracking error by various AMCs reveals that an outright comparison is not feasible.

For example, HDFC MF and ICICI Prudential MF calculate the tracking error based on daily rolling returns for the past 12 months. Nippon MF and SBI MF only consider three-year data, but the latter uses month-end NAV instead of daily value.

Aditya Birla AMC reports the tracking error based on daily rolling returns for a three-year period, for those that have been in existence for more than three years, otherwise it is calculated based on data for the past twelve months.

Some AMCs such as Motilal Oswal MF and DSP MF do not report tracking errors for funds with a historical NAV of less than 3 years. Thus, the difference in methodologies makes the error in monitoring the index funds of the different AMCs incomparable.

As a rule of thumb, most funds try to keep the tracking error below 2%.

Pratik Oswal, Head-Passive Funds, Motilal Oswal Asset Management Company, states that “with the expense ratio being one of the important components of tracking error, investors may also look for funds with lower costs (not necessarily lowest). “


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