Understanding Tracking Error: How It Impacts Your Investment Strategy

With the growing popularity of index funds and ETFs, investors aim to achieve returns that align with benchmark indices like the Nifty 50 and Sensex. But how can you assess whether these funds effectively track their benchmarks? The key lies in tracking error, a vital metric that helps measure a fund’s performance in replicating its index. Though it may sound technical, tracking error has a direct impact on investment outcomes. This blog breaks down the concept, explaining its significance, calculation, and its influence on investment strategies. Whether you're experienced or new to mutual funds, understanding tracking error can offer valuable insights into the performance and suitability of index fund and ETF investments in India.

• Table of contents

• What is tracking error?
• What are the reasons for tracking errors?
• Measures to minimise tracking errors
• Importance of Tracking Error in Mutual Funds
• How to Calculate a Tracking Error?
• Example of Tracking Error Calculation
• What is a Good Tracking Error?
• Factors Influencing Tracking Error
• Benefits of Tracking Error
• Limitations of Tracking Error

What is tracking error?

Tracking error is a measure of the difference in returns of a fund and its benchmark. In the context of an index fund or an exchange traded fund, tracking error indicates how closely your investment matches the target index that it has designed itself on. This can help assess the fund’s performance over time and its relative risk and volatility.

What are the reasons for tracking errors?

Several reasons can contribute to tracking errors:

• Fund expenses: There are charges associated with maintaining a fund, such as management and transaction fees. These expenditures are paid with the fund's money, which means lower returns.
• Cash balance: Funds may need to keep cash for several reasons, such as investor redemption or Income distribution cum capital withdrawal payments. This cash is not invested in the index, resulting in different returns.
• Corporate actions: Stock splits and mergers compel funds to modify their holdings. These modifications might increase expenses and make it more difficult for the fund to match the index.

Read Also: What is Information Ratio in Mutual Funds?

Measures to minimise tracking errors

Minimising tracking errors in an index fund or an exchange traded fund involves several key strategies and considerations.

• Fund management techniques: Fund managers can employ various techniques to minimise tracking errors, such as optimising the portfolio to closely match the index's composition, managing cash flows efficiently, and minimising trading costs.
• Rebalancing: Managers should regularly rebalance the index fund's holdings to align with changes in the benchmark index.
• Transaction costs: The asset management company can minimise transaction costs associated with buying and selling securities within the index fund. High trading costs can erode returns and contribute to tracking errors.
• Tracking error analysis: Regularly monitor and analyse the fund's tracking error relative to its benchmark index. Understanding the sources of the tracking error can help identify areas for improvement and adjustment.

Importance of tracking error in mutual funds

For those investing in index funds and exchange-traded funds (ETFs) in India, tracking error is an important measure of how well the fund is meeting its objective. These funds aim to generate returns that closely follow their benchmark index. A lower tracking error indicates that the fund is successfully mirroring the index, offering investors market-aligned performance. On the other hand, a higher tracking error may lead to noticeable differences from the benchmark, which can result in returns that do not meet expectations. Tracking error helps investors evaluate how efficiently the fund manager executes strategies and whether the fund aligns with their investment approach. It is one of several factors that can be beneficial to consider.

How to calculate a tracking error?

Tracking error is calculated by comparing a fund’s returns with those of its benchmark index over a specific period. Here’s a straightforward method:

• Gather daily or monthly returns of both the fund and the benchmark index for the selected period.
• Compute the difference between the fund's return and the benchmark’s return for each period.
• Determine the standard deviation of these differences. This standard deviation represents the tracking error.

The tracking error formula is typically written as:

Tracking error = Sqrt[(∑(fund returnᵢ - benchmark returnᵢ)²) / (n-1)]

Where:

N is the number of periods.

Fund returnᵢ represents the fund’s return for period i.

Benchmark returnᵢ represents the benchmark’s return for period i.

This calculation gives a numerical representation of the variation between the fund’s returns and the benchmark’s returns.

Example of tracking error calculation

Here’s a hypothetical example: Suppose an index fund tracks the Nifty 50, and the following are its monthly returns over three months:

Month	Fund Return (%)	Nifty 50 Return (%)	Difference (%)
1	2.1	2.3	-0.2
2	1.8	1.7	0.1
3	-0.5	-0.4	-0.1

Calculate the differences: -0.2, 0.1, -0.1.

Square the differences: 0.04, 0.01, 0.01.

Sum the squared differences: 0.06.

Divide by (n-1): 0.06 / 2 = 0.03.

Take the square root: 0.03 ≈ 0.173.

Therefore, the tracking error for this example is approximately 0.173%, or 17.3 basis points. This means that the fund's returns have deviated from the Nifty 50's returns by approximately 17.3 basis points on average per month.

What is a good tracking error?

Determining a good tracking error in Indian mutual funds depends on the index fund or ETF and its benchmark. A lower tracking error indicates that the fund’s returns are closely aligned with the benchmark. Generally, a tracking error below 0.5% (50 basis points) is considered relatively low. However, acceptable tracking error levels vary. Funds tracking highly liquid indices like the Nifty 50 or Sensex typically have lower tracking errors than those following less liquid or specialized indices. Instead of focusing on a specific number, it is more useful to compare tracking errors among similar funds. When evaluating index funds, investors should consider tracking error alongside other factors like expense ratios and the fund’s investment objective.

Factors influencing tracking error

Several elements contribute to tracking error in Indian mutual funds:

• Expense ratio: Higher expense ratios reduce fund returns, leading to a greater divergence from the benchmark.
• Cash holdings: Funds may hold some assets in cash, which can result in underperformance during market rallies.
• Sampling techniques: Some funds use sampling instead of holding all index constituents, which may introduce tracking error.
• Regulatory restrictions: Certain investment constraints or regulatory limitations may prevent exact index replication.
• Dividend reinvestment: The timing and method of reinvesting dividends can create small return differences between the fund and its benchmark.

Benefits of tracking error

While minimizing tracking error is generally preferred, understanding it offers several advantages:

• Performance evaluation: It provides a numerical measure of how well a fund tracks its benchmark.
• Fund comparison: Investors can compare similar index funds or ETFs to identify those that more closely follow their benchmarks.
• Risk assessment: It helps gauge the extent of a fund’s deviation from its benchmark.
• Transparency: Tracking error enhances transparency by showing how closely a fund aligns with its stated objective.
• Investment decisions: It is one of several factors that can be beneficial in making informed investment choices.

Limitations of tracking error

Despite its usefulness, tracking error has some limitations:

• Past performance: It is based on historical data and may not accurately indicate future performance.
• Short-term fluctuations: It may not capture temporary deviations from the benchmark.
• Index changes: Adjustments in the benchmark’s composition or methodology can affect tracking error.
• Expense ratio changes: Changes in a fund’s expense ratio will directly impact its tracking error.

Read Also: Tips to choose the right index fund for your portfolio

Conclusion

Data on tracking error helps you assess how your fund is performing relative to its benchmark. For an index fund or a passively managed fund, too much variance, especially over multiple periods, can be indicative of high volatility. It is therefore important for investors to look at tracking error data when evaluating their investments.

FAQs

What is a tracking error in mutual funds?

Tracking error measures how much a fund's returns differ from its benchmark index. It reflects how accurately a fund follows the index's performance. A lower tracking error suggests closer alignment.

How is tracking error calculated?

It is calculated as the standard deviation of the difference between the fund's returns and the benchmark index's returns over a specific period.

What is the tracking error formula?

Tracking error is measured using the formula: standard deviation of (Fund Returns - Benchmark Returns). This helps quantify how much the fund’s performance fluctuates from its benchmark.

What does a low tracking error indicate?

A low tracking error means the fund closely follows the benchmark index’s returns. This is common in index funds and ETFs designed to replicate index performance.

What are some of the sources of tracking errors?

Factors include fund management expenses, cash holdings, portfolio sampling differences, and delays in adjusting holdings. Regulatory restrictions on certain stocks can also cause deviations.

How does tracking error impact mutual fund performance?

A higher tracking error means greater divergence from the benchmark's returns. This can result in fund performance being either higher or lower than expected, influencing overall portfolio outcomes.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
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