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.

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.

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.

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