Guide to Tracking Error of Mutual Funds
(This
is for information purposes only. This should not be construed as a
recommendation or investment advice even though the author is a CFA Charterholder. Please consult your financial
adviser before taking any investment decision. Safe to assume the author has a vested
interest in stocks / investments discussed if any.)
1. Mutual Fund Basics
While selecting mutual funds, investors have to consider a variety of important factors. One such factor is tracking error.
Mutual funds are pools of money managed by professional managers on behalf of investors. They are basically two types of mutual funds from the point of investment management. They are active and passive funds.
As the name suggests, with active funds fund managers have the discretion to select securities they deem fit within the objectives of a specific mutual fund scheme.
Passive funds, on the contrary, are managed passively -- meaning fund managers do not have any discretion to choose securities. Instead, they have to mimic the securities in the same proportion in a benchmark index on which the passive fund is based.
Passive funds include index funds as well as exchange-traded funds (ETFs).
For example, an equity fund named Navi Large & Midcap is an active fund managed jointly by fund managers, Aditya Mulki and Ashutosh Shirwaikar. Within the investment objective of the fund, the managers choose the stocks and manage the money pooled on behalf of the investors.
You take another fund, this time from the passive universe, namely, Edelweiss Nifty Midcap 150 Momentum 50 Index Fund. This passive fund tracks its benchmark index, that is Midcap 150 Momentum 50 index, and chooses the same stocks from the index in the same proportion as they are in the index.
Now let us talk about our main topic of the blog, that is, understanding tracking error in mutual funds.
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Related Blogs on Mutual Funds:
NSE Indices (Nifty 50, Nifty Next 50, Nifty 100 and Nifty 500) Comparison 31Dec2022
Who is Eating My Gold ETF Return?
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2. What is tracking error?
Tracking error is a feature of both active and passive funds. The focus of the article is toward passive funds. Hence, let us find out what a tracking error is in passive mutual funds.
The returns of a passive fund are supposed to be close to the returns of its benchmark index. Take for example, Motilal Oswal Nifty 500 index fund. Its benchmark index is Nifty 500 TRI (total return index).
The fund's one-year return is 39.4 percent; whereas the fund's benchmark index delivered a return of 40.8 percent for the same period (data as of 31Mar2024).
Though the fund is supposed to closely track the performance of its index, it has delivered lower one-year returns than the index -- this is true in case of long-term returns also.
Why is the fund unable to deliver the promised return? This is due to the tracking error. As mentioned above, tracking error is a feature, not a bug, of passive funds.
3. Causes behind tracking error
The tracking error in ETFs and index funds occurs due to some factors, like:
1. The fund has to maintain a small component of cash in the fund because investors put money into the fund on a daily basis and they also tend to redeem money on a daily basis.
2. The fund manages money on behalf of investors and they charge a fee, called expense ratio, for such management.
3. The fund has to account for corporate actions, like, dividends, buyback of shares, bonus shares and others. Practically, there may be some delay in receiving proceeds of dividends, buyback of shares and others.
4. The benchmark indices, on which passive funds are based, undergo changes regularly with securities being added and deleted. Based on the changes, the fund has to trade (buy or sell based on the underlying index changes) in securities. This may result in some differences in weights of the securities between the fund and its underlying index.
5. In some cases, the securities underlying the index may suffer from lack of liquidity resulting in tracking error.
In general, expense ratios of passive funds (ETFs and index funds) account for a substantial portion of their tracking error in relation to their benchmark indices.
Fund managers continuously monitor the tracking error of a particular scheme and generally speaking they try to restrict the tracking error to the minimum, say, less than 2 percent.
4. How is it calculated?
Tracking error is basically a statistical tool and it is defined as the annualised standard deviation of the difference between daily returns of the underlying index and the net asset value (NAV) of the fund.
And it is expressed as a percentage. Let us not go into the mechanics of its actual calculation as it's outside the scope of the article.
Different mutual fund houses (AMCs or asset management companies) use different methods for calculating tracking error. Some use daily returns for the past one or three year periods and some use monthly returns for the past one or three years.
Strictly speaking, tracking errors of a particular fund house may not be comparable with those of other fund houses. AMCs use the NAV (net asset value) of their passive funds while calculating tracking error.
For example, Nippon India AMC calculates the tracking error of its passive funds based on daily returns for the past one year.
Aditya Birla Sun Life AMC reports tracking error of its funds based on monthly returns for the past three years.
In case of ETFs, NAVs are used; but not prices of ETFs quoted on stock exchanges, like, NSE or BSE. As such, tracking error you see in a mutual fund factsheet for an ETF is based on the NAV of the ETF.
If you use ETF prices on BSE / NSE, the tracking error may be different as prices and NAV may not be same. As such, investors should assess whether the ETF price quoted on a stock exchange is vastly different from the ETF's NAV.
It may be noted mutual funds should declare intra-day or indicative NAV or iNAV of ETFs on a continuous basis, in 15-second intervals, on stock exchanges on all trading days. In addition, they declare NAV of ETFs at the end of a trading day also.
Due to investor interest and market demand, there are times when the prices of certain ETFs on stock exchanges may be quoting at a huge premium to the actual NAVs. Selecting such ETFs for investment is fraught with danger.
The ETF prices may sometimes be quoting at a discount to their declared NAVs also.
5. What are the actual tracking errors?
The analysis is restricted to tracking error of passive funds of select mutual fund houses, namely, HDFC Mutual Fund, ICICI MF, Motilal Oswal MF, Nippon India MF and SBI MF.
One caveat here as only five fund houses are considered for this analysis, the assessment could be different from what is described here if you take the tracking error data of all the 43 fund houses in India.
However, the data considered for the analysis is a good sample in the total population. The raw data considered for the analysis can be found at the end of the blog.
There are 172 passive funds from these five AMCs, as per data from AMFI India – of which, seven are funds based on commodities (gold and silver), 35 are from debt category, four are international funds and 126 are equity passive funds.
All the data are from AMFI India website and are as on 31Mar2024. AMFI India is a self-regulatory body of mutual funds in India.
In general, debt passive funds (both ETFs and index funds) have higher tracking error compared to equity funds. From this, one can deduce that debt passive funds are less efficient from investors’ point of view, compared to equity passive funds (include ETFs as well as index funds).
Obviously, investors have been showing greater interest and participation with equity funds compared to debt funds.
A. Regular versus direct plans
In many cases, regular plans of debt and equity passive funds have the same tracking error. But in certain cases, direct plans have slightly lower tracking error compared to their regular plans – but these differences are negligible in most cases.
For example, Nippon India Nifty Bank Index fund has a tracking error of 0.18 percent for its regular plan and 0.17 percent for its direct plan.
HDFC S&P BSE 500 Index fund’s tracking error is 0.13 percent for regular plan and 0.12 percent for direct plan. However, ICICI Prudential Nifty Bank Index fund’s regular plan has a tracking error of 0.21 percent, but its direct plan has a tracking error of 0.08 percent only.
B. Exchange-traded funds versus index funds
There are some differences between tracking error of an index fund and ETF of the same fund house with the same benchmark index.
For example, the benchmark index of Motilal Oswal Nifty 200 Momentum 30 ETF and Motilal Oswal Nifty 200 Momentum 30 index is the same, namely, Nifty 200 Momentum 30 TRI.
But their tracking errors are different. The Motilal Oswal Nifty 200 Momentum 30 ETF’s tracking error is 0.15 percent and its counterpart index fund’s tracking error is 0.20 percent.
As passive funds based on broad-based indices, like, Nifty 50, Nifty Next 50 and BSE Sensex have wider investor interest, high trading volumes and low bid-ask spreads (in case of ETFs based on such indices), large assets under management and lower expense ratios, their tracking errors tend to be lower.
Moreover, there is not much difference in tracking errors of these ETFs and index funds. For example, the tracking errors of ICICI Prudential S&P BSE Sensex ETF and ICICI Prudential S&P BSE Sensex Index fund (direct plan) are 0.04 percent and 0.05 percent respectively.
C. Sectoral / thematic funds versus funds based on broad-based indices
Sectoral funds and thematic funds tend to have higher tracking error compared to passive funds based on broad indices, like, Nifty 50, Nifty Next 50 and BSE Sensex. Relatedly, sectoral / thematic funds tend to have higher expense ratios also.
Let us take Motilal Oswal S&P BSE Low Volatility Index Fund, a thematic fund, as an example. Its tracking error is 0.37 percent, whereas, ICICI Prudential Nifty Pharma Index Fund, a sector fund, has a tracking error of 0.27 percent.
At the other end, SBI Nifty Next 50 ETF has a tracking error of 0.06 percent. Another passive fund, namely, ICICI Prudential S&P BSE Sensex ETF (based on a broad index, like Sensex) has a tracking error of just 0.04 percent.
The highest tracking errors are from passive funds based on mid- and small-cap indices. Let us take Motilal Oswal Nifty Smallcap 250 ETF; it has a tracking error of 1.34 percent. Motilal Oswal Nifty Midcap 100 ETF has a tracking error of 0.34 percent.
The lowest tracking errors are from passive funds, based on BSE Sensex, Nifty 50, Nifty Bank, Nifty Private Bank and others.
6. Summary
Tracking
error shows how closely a passive fund is able to track the performance of the
underlying index. A lower tracking error indicates that the passive fund is able
to match the performance of the underlying index with a smaller
deviation.
The lower the error, the more desirable the passive fund from the investor's viewpoint.
However, it’s not a good idea to base your investment decisions depending solely on a single metric, like, tracking error of mutual funds.
The attraction of passive funds is they are simple to understand. They also have lower expense ratios compared to active funds.
Compared to passive funds in developed economies, passive funds in India have higher expense ratios.
However, some passive funds in India based on popular stock indices, like, Sensex, Nifty 50 and Nifty Next 50, have low expense ratios.
Another alluring feature of passive funds comes from the fact that active funds globally, over six decades, have failed to beat passive funds.
Most of the investors will be better off investing a substantial portion of their surplus money in passive funds.
The preference for selecting such passive funds should be based on factors, like, suitability of the fund, good and appropriate portfolio diversification, size of assets, lower expense ratios, minimal tracking error and high liquidity (like, trading volumes and low bid-ask spread in case of ETFs).
Passive Funds to avoid are:
1. Funds with highest expense ratios, like, sectoral and thematic funds.
2. Funds based on narrow indices, like, Bharat 22 ETF and CPSE ETF. They suffer from lack of portfolio diversification.
3. Funds based on indices, where the underlying stocks have limited liquidity. In event of a market crash, passive funds will not be able to liquidate their holdings if the underlying stocks have low liquidity on stock exchanges and will not be able to meet the redemption needs of investors.
5. It is not advisable to choose passive funds which have very high annualised tracking errors, like, more than 0.30 to 0.40 percent. This is just a broad range for tracking error, the numbers are not cast in stone -- there is no scientific basis for this range. This is just a range comfortable from the author's viewpoint.
As pointed out in an article by Value Research Online, some ETFs are currently selling at a huge premium to their declared NAVs. This is the due to fact that capital market regulator, SEBI or Securities Exchange Board of India, has shut the door on new money flows into international funds.
This has created a distortion in markets, whereby certain ETFs based on foreign indices are now quoting in stock exchanges at a huge premium to their NAVs. It's better to avoid investing in such ETFs that are quoting at a huge premium to NAVs.
Please beware of the risks involved in passive funds before investing. This is not a recommendation for any of the funds mentioned here -- they are used for illustration purposes only. Prospective investors must consult their financial adviser before making any investment decisions.
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References and additional data:
Tweet 25Apr2024 on tracking error
Value Research - avoid investing in overseas ETFs quoting at a huge premium
Vanguard on tracking error
AMFI data for AMC-wise tracking error
Tables 1 and 2: Commodities, debt and foreign funds (raw data of tracking error) >
(please click on the images to view better)
Tables 3 to 7: passive equity funds (raw data of tracking error) >
(please click on the images to view better)
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Read more:
AMFI List of Market Cap: Categorization of Large-, Mid- and Small-Cap Stocks
BSE 500 versus S&P 500 Indices Compare 31Dec2023
Disclosure: I've got a vested interest
in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if
any.
Disclaimer: The analysis and
opinion provided here are only for information purposes and should not be construed
as investment advice. Investors should consult their own financial advisers
before making any investments. The author is a CFA Charterholder with a vested
interest in financial markets.
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