Let’s consider an analogy first to understand this concept -
Assume you book a cab to reach a specific destination. The route is clear on the map, and you expect the driver to follow it precisely. However, traffic jams, road repairs, or sudden detours make the journey take a little longer or lead to a slightly different route. In the end, you reach the destination but not quite in the exact manner or time you planned.
Now, think of passive investing in a similar manner. Passive mutual funds are designed to track the performance of a specific index. While the goal is to stay as close to that benchmark as possible, certain real-world obstacles can lead to slight deviations. These deviations are measured in the form of tracking errors.
The effectiveness of a passive fund lies in how well it mirrors its benchmark. Let us help you better understand the concept of tracking error.
What is a Tracking Error?
Tracking error measures how much the returns of a passive fund differ from the returns of the index it tracks over a specific period. Practical factors like management costs, cash holdings, or market conditions can create slight variations in investment performance, which is what tracking error represents. This error is typically expressed as a percentage. A lower tracking error may indicate that the fund is more efficient in following the index closely. Conversely, a higher tracking error might suggest inefficiencies impacting the fund’s ability to track the index.
You can consider tracking errors an important parameter to assess the performance of a passive investing approach. It’s also about how much returns you can expect from a passive fund and how consistently it mirrors the index over time.
How Can Tracking Error Affect Investment Performance?
Tracking error might sound like a technical term, but its impact on your investment performance is easy to understand, let’s look at simple examples: You invest in a ABC index fund. In a year, the ABC Index generates a return of 10%. Your fund is expected to deliver similar returns. However, the fund returns 9.5%. This gap represents the tracking errors.
Now, let’s consider two mutual funds: Fund A and B have tracking errors of 0.2% and 1.2%, respectively. Over a five-year period, Fund A’s closer alignment with the index may mean your returns closely match the index’s performance. Fund B, however, shows more variability, leading to potential shortfalls in the expected returns.
How to Minimise Tracking Error in Passive Funds?
While an investor cannot directly minimise tracking error, they can take steps to choose funds that are better managed and more likely to deliver returns closely aligned with the benchmark. Here are a few practical ways to ensure your passive investments stay as close to the benchmark as possible:
1.Compare Expense Ratios Across Similar Funds
You can avoid looking at the expense ratio in isolation when selecting a passive fund. Instead, you can compare it with other mutual funds tracking the same index to decide better.
2. Look for Efficient Fund Management
You may select funds managed by trusted AMCs with a proven track record of replicating indices effectively. Efficient fund management may help minimise deviations caused by cash holdings or mismanagement.
3. Be Mindful of Frequent Rebalancing
Funds that frequently rebalance their portfolios to align with the index might face additional costs and potential tracking errors. While rebalancing might be necessary to maintain alignment with the benchmark, you can consider how often it occurs.
How to Use Tracking Error to Gauge a Fund’s Effectiveness?
1. You can consider the tracking error over a longer time horizon, such as 3 to 5 years. A consistently low tracking error can be a sign that the fund reliably tracks its index. In contrast, significant fluctuations in tracking error could signal problems in the fund’s strategy or management.
2. You can check the impact of tracking errors on long-term returns. Over an extended period, even small deviations from the index may compound.
3. A fund might be a good fit if it aligns better with your overall strategy or offers other advantages, like lower fund management cost or superior liquidity, irrespective of the tracking error. However, if your goal is a precise replication of the index, you might want to prioritise funds with minimal tracking error.
While a passive investing strategy may not guarantee complete alignment with the index performance, considering tracking errors can be the difference between meeting your expectations and missing the mark.
Mutual Fund Investments are subject to market risks, read all the scheme related documents carefully.
