Importance of Tracking Error

• Measures consistency: 

  A low tracking error is desirable for index funds and ETFs because it indicates the fund is reliably replicating its benchmark, making its performance predictable. 

• Gauges active management: 

  A high tracking error, also known as “active risk,” signals a greater deviation from the index, which is often seen in actively managed funds aiming to outperform the benchmark. 

• Reveals inefficiencies: 

  It can highlight potential issues like high expense ratios, which increase the cost of managing the fund, or cash drag from keeping too much money on the sidelines. 

• Assists in fund comparison: 

  Tracking error allows investors to compare different funds with the same benchmark, helping to identify which one is a more accurate and efficient replica. 

• Informs trading decisions: 

  For frequent traders or those using hedging strategies, tracking error is a crucial tool for understanding how much the fund’s price might deviate from the index’s price in the short term. 

  Factors that cause tracking error

• Expense Ratios: 

  Fund management costs and operational expenses can directly contribute to a higher tracking error.

• Cash Holdings: 

  Funds often hold a small percentage in cash or other liquid assets to manage redemptions or dividend inflows, which can create a tracking difference.

• Rebalancing: 

  Delays in rebalancing the portfolio to match the index, especially after significant market movements, can increase tracking error.

• Liquidity: 

  Low liquidity in certain stocks within an index can make it difficult for a fund to buy or sell those stocks at the desired prices, increasing the tracking error.

• Portfolio Construction: 

  How the fund manager builds the portfolio can cause deviations. For example, a fund might have a one-sided weight in certain stocks or sector. 

  Key aspects of tracking error

  • 1. Definition: 

       It’s the standard deviation of the difference in returns between a fund and its benchmark. This indicates the volatility of the fund’s performance relative to the index.

       Relevance for different funds:

       Passive funds (Index Funds, ETFs): These funds aim to replicate an index. Tracking error is a key metric to measure how well they achieve this goal. A low tracking error is desirable, indicating the fund closely follows the index’s performance. 

       Active funds: These funds aim to beat the market or their benchmark. They may have a high tracking error because their portfolios are not designed to mimic the index. 

       Causes of tracking error: 

       Several factors contribute to the difference in returns:

       Expenses: Management fees and other costs reduce a fund’s returns compared to the index. 

       Cash holdings: Funds often hold a cash position to manage redemptions, which can generate lower returns than the index. 

       Trading costs:Buying and selling securities to match the index involves transaction costs. 

       Index changes:Corporate actions like mergers or changes in the index can lead to tracking differences. 

       Rebalancing delays:There can be a lag in rebalancing the fund’s portfolio to match the index. 

       Interpretation:

  A high tracking error may indicate that the fund is not performing as intended (for a passive fund) or is taking on significant “active risk” (for an active fund). 

  For an index fund, a low tracking error is generally preferred, as it shows the fund is efficiently tracking its benchmark. 

  Importance of Tracking Error in Mutual Funds

  These pointers indicate the importance of tracking error –

  • Tracking error helps measure and compare a portfolio’s performance with its concerned benchmark or index.
  • It enables the gauge of the consistency of excessive returns.
  • It helps to convert the difference between an investment portfolio and the concerned benchmark into a one-digit number for better comparison and understanding.
  • It helps portfolio managers to ascertain how close a portfolio is to the benchmark.
  • Tracking error is a neutral point and allows portfolio managers to make informed decisions.
  • It helps investors to ascertain the significance of differences between the returns of benchmark and portfolio.
  • Further, it helps to determine how active and proficient a portfolio manager’s investment strategy is.