Tracking Error in Index Funds - Definition | Causes | Example | How to Avoid it | Learn with ETMONEY

An Index fund is judged on its ability to replicate 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?

In this video, we talk in detail about the Tracking error, its causes, and how investors should use it while picking an Index fund.

Topics Covered:
00:00 Introduction
01:13 WHAT IS A TRACKING ERROR?
05:24 WHAT CAUSES TRACKING ERRORS?
07:15 WHAT SHOULD INVESTORS DO?

What is the Tracking Difference?
A tracking difference is quite simply the difference between the performance of an index fund and the benchmark it is tracking. Interestingly, this tracking difference need not always be negative and sometimes we see a few index funds even outperforming the benchmark
WHAT IS A TRACKING ERROR?
Unlike how it is commonly perceived the tracking error is not about performance but rather, a tracking error is about the variability of performance. In other words, the tracking error indicates the consistency of a product’s tracking difference during a time period. The tracking error indicates the consistency of a product’s tracking difference and this is why it was important to explain both these terms. And since a tracking difference is nothing but the difference between the total return performance of a fund and the total return performance of its underlying index.

The tracking error is the annualized standard deviation of the tracking difference.

Investors commonly consider tracking errors in fund selection decisions but iit'snot as easy as it comes and one has to be extra careful about it.
Inconsistency in tracking error reporting

Some fund houses were very selective about reporting tracking errors. Our report found the tracking error was reported for only some of the index schemes but not for some other index schemes they had.
We noticed that the methodology for calculating the tracking error was different for different AMCs

What should you do?

account for this pliability of statistics when comparing funds.
Pull out the historical NAV information from the AMC website and do the tracking error calculations yourself on a spreadsheet

WHAT CAUSES TRACKING ERRORS?
Many reasons lead to tracking errors
1. Mutual fund expenses:
expenses can’t be avoided there is a cost to buying & selling stocks, management expenses, administration of the fund, etc. And as a thumb rule, the higher the expenses, the greater might be the tracking error. It is the fund manager’s job to keep the tracking error at its lowest .. and they do this by using several techniques which include - rebalancing the portfolio, managing dividends, lending securities, using index futures, and even temporarily investing in fixed income products

2. The cash balance in the index fund:
It’s a known fact that most, if not all, mutual fund schemes are never 100% invested. They leave aside anywhere from 2 to 5% in cash or highly liquid debt instruments that can then take care of redemptions. Likewise, any declaration of dividend or a sudden surge in investment inflows means more cash to work with and the fund house is likely to take some time to reinvest this money which will then show up in the tracking error calculations.

3. Inability to buy or sell the underlying index stocks due to sudden market movements or poor liquidity:
The imbalance caused by a larger-than-normal bid-ask spread increases the level of volatility ... which then has a bearing on the tracking error. This situation can generally be seen in sectoral or thematic funds which tend to have a larger tracking error

WHAT SHOULD INVESTORS DO?
Investors need to start viewing the tracking error as an indicator of how actively a fund is being managed and its corresponding risk level. In fact, instead of looking at just the present number investors should look to study the tracking error across a few quarters which’ll give a great signal into the risk control practices and help understand if the scheme might be taking unwarranted risks like lopsided index weightage or buying stocks out of weightage or holding onto more cash, etc.

In essence, it is most ideal to invest in an index fund that has a low tracking error but it need not be the lowest.

In fact, one can make this selection process more scientific .. by giving a higher weightage to those index funds whose tracking error is lower than the average of all other index funds that carry the same benchmark

#ETMONEY #Trackingerror #learnwithETMONEY #mutualfunds

👉 Follow us on:

[anandts]

Request ET Money to add tracking error details as calculated by your team for info of investors who use your app. Instead of putting Index funds under Large Cap request that it be made as seperate segment for ease of investors. It would be of a great help to many, Regards, Lt Col TS Anand

[rakshiths.n]

Video on Rebalancing pls as promised...

[vrn]

From where we can see tracking error for particular fund? It is also not available at ET money app

[hirenc]

Why only few lacks subscribers. We should share this to many people & let them make a educated decesion by themself. Let us all share this to as many possible persons & make them financially literate and grow our nation.

[manishkaul]

Thanks for the valuable content on index fund (it's hard to find content, let alone good content on index fund particularly, not sure why). Anyway,
When you say checking the history of NAVs of a particular AMCs index fund for calculating tracking error myself, I also will need to factor in the corresponding value of the index as well right ?
Would I get that information about the corresponding index movement on the AMCs website itself or would I have to check that on the respective stock exchange's website for the same dates ?

[rdsk]

Good explanatory video on tracking error and difference. Since tracking error is a standard deviation measure, it always gives a positive number. How could one use it to understand whether a fund has outperformed or underperformed it's index?

[KaranJoshan]

Sir i want to invest some money in index funds nifty 50 or nifty next 50 . Can you tell me the name of which company fund to choose . I want to invest an sip of rs 4000 every month. Pls guide me .

[bighnarajmisra]

Fabulous, All the topics are immense help to retail investors ....

[sureshtimepass]

Sir make on best index mutual fund with less tracking error please ...

[hjag]

Where can we find a comparative list of index MFs with the index they track, tracking errors, expense ratio etc?

[fakegeek]

Create a video on upcoming Quant funds by all AMCs

[SD_]

Am invested in hdfc sensex index and sbi nifty index funds. Good to see their tracking error is less

[prakashraghunathan]

Please Sir make a video on rebalanced of portfolio.

[rakkuwin]

Sir am et money user z guide mutual fund vs index fund which is best for long term

[aaronthomas]

‌Investing in crypto now should be in every wise individuals list, in some months time you'll be ecstatic with the decision you made today.

[kyojurorengoku]

Is IDFC nifty 50 index fund good for investment?

[jatinmehta]

We will not be making apple to apple comparison of index funds using tracking error because calculation methodology differs amongst fund house. It is imperative that SEBI has a rule in place for calculating all statistical parameters across fund houses.

[trpaarvai]

Thanks for sharing the reasons for tracking error. It was very informative.

[venkateshrao]

Is there any way to findout the rise and fall or decline in AUM and does this gives us an indication for us to decide whether to Invest in this fund or avoid.

[pjaydeep]

I learnt something new today. Thank you.