According to AMFI, tracking error is the difference between an ETF portfolio’s returns and the benchmark or index it was meant to mimic or beat.
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ETFs and index funds, much like other mutual fund schemes, incur expenses on cost heads, such as marketing, advertising, office administration, brokerage and so on. These expenses reduce the ETF’s returns. The ETF may also receive dividends from the underlying stocks which may temporarily lead to the ETF out-performing the benchmark. This deviation in performance is nothing but the “tracking error” and is expressed in percentage terms. Tracking error is sometimes called active risk. How well an index fund manages its inflows and outflows also determines tracking error. The lower the tracking error, the better the ETF / Index fund, according to AMFI.
Tracking error = standard deviation of (P-B)
Where, P = portfolio return
B = benchmark return A low tracking error indicates that the fund closely follows its benchmark, while a high tracking error suggests 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 which are associated with buying and selling of stocks, fund management expenses, administration 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, the fund managers use various techniques such as rebalancing the portfolio, using index futures, managing dividends, and also investing in debt/fixed income instruments.
- Cash Holdings: Mutual funds often hold a portion of their assets in cash to manage redemptions or make more investments during the dip. This cash holding may not perform in line with the benchmark, leading to tracking error.
- Rebalancing: Funds periodically rebalance their portfolios to maintain alignment with the benchmark. However, market conditions and transaction costs can affect the fund’s ability to match the benchmark precisely.
Tracking error in some cases is caused due to the scheme’s inability to buy and sell the underlying securities. This problem occurs due to low liquidity or sudden volatility in the market which increases volatility of specific stocks.
- Dividends: The timing and reinvestment of dividends can also cause tracking error. While benchmarks assume dividends are reinvested immediately, funds may face delays.
- Sampling Strategy: Some funds may use a sampling approach, holding a subset of the securities in the benchmark. This can lead to differences in performance if the sampled securities perform differently than the overall benchmark.
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Why should investors care?
For the investors, tracking error is an essential indicator which tells how well a mutual fund replicates its benchmark. A fund with a low tracking error is generally more desirable, as it suggests the fund manager is effectively replicating the benchmark. Conversely, a high tracking error may indicate inefficiencies or challenges in the fund’s management. Therefore, an investor should look for that scheme which has low tracking error to ensure that their investments mirrors the chosen benchmark accurately.
How to Evaluate Tracking Error?
Investors can evaluate tracking error by reviewing a fund’s historical performance relative to its benchmark. Most financial websites and monthly fund factsheets provide tracking error data. It’s important to compare this with 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 the efficiency of a mutual fund in replicating its benchmark. By understanding and monitoring tracking error, investors can make more informed decisions and choose funds that align with their investment goals.
