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Concept of tracking error for the Index Funds
14 Mar 2023

An index fund is a form of passive fund which looks to replicate the index like the Sensex or the Nifty. The fund will be essentially judged by how well it replicates the index. The extent to which the index fund does not track the index is popularly referred to as the Tracking Error. The ideal measure of an index fund is how low is the tracking error of the fund? Let us understand index funds tracking error in much greater detail. Tracking error for index funds is a core metrics on which the performance of the index fund is measured. What is a good tracking error for index fund and what is not?
Let us understand the concept of tracking error with the fact sheet of the HDFC Index Fund which tracks the Sensex.

In the HDFC Index Fund above the annualized tracking error is 0.07%. This is an extremely low and healthy tracking error and is indicative of the fact that the HDFC Index Fund tracks the index very closely. Lower the tracking error of the index fund, better the performance of the index fund. But why exactly does tracking error occur?

Why does tracking error occur in index funds?

Broadly, there are 3 reasons why tracking errors in index funds that cause the difference between the index performance and the actual fund performance..

Firstly, the index is a dynamic combination and the index committee will keep changing the constituents regularly. For example, the Nifty recently added Grasim and Bajaj Finserv into the Nifty Index and removed two stocks from the index. Till the time the index fund manager also adjusts the fund holdings accordingly, there will be tracking error present in the fund.

Occasionally, funds face redemption pressure from investors. As long as the inflows into the fund are greater than the outflows there is no problem. However, when the outflows exceed the inflows it leads to shares being sold to cover these redemptions. This will lead to changes in the index fund and will ensure that they are not in sync with the index.

Finally, there is the issue of dividends. Normally, dividends are not adjusted for dividends but the fund that holds these shares will receive these dividends. This will again lead to differences between the fund values and the index value. The transaction costs and the expense ratio of the fund also play a part in determining the variance of the index fund performance from the actual index. The dividends act as a cushion against the negative impact of transaction costs and expense ratio. Index Fund overview

How do we define tracking error?

Let us understand the concept of tracking error in simple terms. Let us assume that the index has gained 4% in a month and if the index fund has gained only 3.5% in the month, then the monthly tracking error is 0.5%. Even if the return on the fund is 4.5%, the tracking error will still be 0.5%. Normally, this tracking error is annualized and presented in the fact sheet. Tracking error also occurs when the fund does not own all the securities in the index as an alpha generating measure. For example, if the banking sector is doing better the fund may look to add a little more of banking stocks to their portfolio and reduce other stocks in the index leading to variance from the index returns.

How should investors interpret Tracking Error?

Tracking error is the extent to which the portfolio of the index fund does not track the core index. Here are 5 ways to interpret the tracking error..

When you invest in an index fund it is essential to select the fund with the lowest tracking error. Normally, tracking error is evaluated based on the annualized number. While there is not official cut-off you must select the index fund that is lower than the benchmark average.

Apart from the annualized tracking error, it is essential to also look at the variance of the tracking error. A low tracking error that is stable is better than a tracking error that is low on an average but is showing high degree of variance.

Tracking error is required to be disclosed by index funds as part of their fact sheet. Apart from the absolute number of the tracking error also look at the trend in the tracking error. That is more instructive from an analytical perspective. Index funds versus ETFs: Choosing the right passive investment

Tracking error is negatively impacted by the transaction costs and the expense ratio of the fund. But the fund manager has the cushion of the dividends, which are not included in the calculation of the index value. However, this could change if the Total Returns Index is considered instead of the Absolute Returns Index. To that extent the index funds may underperform as they will lose the cushion of dividends.

What fund managers actually do is to create a portfolio the mirrors the index performance as close as possible. Tracking error works both ways; i.e. outperforming the index and underperforming the index. Substantial returns over the index are also not a great signal as it will mean that the fund manager may be taking unwarranted risk on the index portfolio. That again defeats the purpose of indexing.




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