Explanation: What is tracking error in mutual funds and what does it mean for investors?

Tracking error is the difference between the performance of the scheme and that of the benchmark. It measures to what extent a mutual fund scheme has replicated the returns of its benchmark. The higher the deviation from its benchmark, the higher the deviation. benchmark index The higher the performance, the higher the scheme tracking error.

According to AMFI, tracking error is the difference between the performance of an ETF portfolio and the benchmark or index it is intended to mimic or outperform.

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ETF (exchange-traded funds) Index funds, like other mutual fund schemes, incur expenses for cost concepts such as marketing, advertising, office administration, brokerage, etc. These expenses reduce the returns of the ETF. The ETF may also receive dividends from the underlying stocks, which may temporarily cause the ETF to outperform the benchmark index. This deviation in performance is nothing more than the “tracking error” and is expressed in percentage terms. Tracking error is sometimes referred to as active risk. How well is a tracking error calculated? index fund The management of capital inflows and outflows also determines the tracking error. The lower the tracking error, the better the ETF/index fund, according to AMFI.

Tracking error = standard deviation of (PB)

Where, P = portfolio return

B = Benchmark performance A low tracking error indicates that the fund closely tracks its benchmark, while a high tracking error suggests a greater deviation.

What causes tracking error?

Several factors contribute to tracking error in mutual funds:

• Expense ratios: Mutual funds have various expenses, such as costs associated with buying and selling shares, fund management fees, and administrative charges. Higher management fees and expenses can erode returns, causing the fund to underperform its benchmark.
• To minimize or reduce the tracking error due to these expenses, fund managers use various techniques such as portfolio rebalancing, use of index futures, dividend management and also investment in debt/fixed income instruments.

• Cash holdings: Mutual funds often hold a portion of their assets in cash to manage redemptions or make further investments during a downturn. cash holdings It may not perform according to the benchmark, resulting in tracking error.

• Rebalancing: Funds periodically rebalance their portfolios to maintain alignment with the benchmark. However, market conditions and transaction costs may impact the fund’s ability to accurately match the benchmark.

In some cases, tracking error is caused by the system’s inability to buy and sell the underlying securities. This problem occurs due to low liquidity or sudden volatility in the market that increases the volatility of certain stocks.

• Dividends: The timing and reinvestment of dividends can also cause tracking errors. While benchmarks assume that dividends are reinvested immediately, funds may experience delays.

• Sampling strategy: Some funds may use a sampling approach, holding a subset of the securities in the benchmark. This can result in differences in performance if the sampled securities perform differently than the overall benchmark.

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Why should investors care?

For investors, tracking error is an essential indicator that indicates how well a mutual fund replicates its benchmark. A fund with a low tracking error is usually more desirable as it suggests that the fund manager is effectively replicating the benchmark. Conversely, a high tracking error may indicate inefficiencies or problems in the management of the fund. Therefore, an investor should look for a plan that has a low tracking error to ensure that their investments accurately reflect the chosen benchmark.

How to evaluate tracking error?

Investors can assess tracking error by reviewing a fund’s historical performance relative to its benchmark. Most financial websites and monthly fund fact sheets provide data on tracking error. It is important to compare this to other similar funds to understand how well the fund is managed and how well it has performed.

Tracking error is a key metric that reflects how efficiently a mutual fund replicates its benchmark. By understanding and controlling tracking error, investors can make more informed decisions and choose funds that fit their investment objectives.