When you invest in any Mutual Funds especially in Index Funds and view the fact sheet you notice the comparison of returns from some benchmarks like NIFTY, BSE, Banking NIFTY etc. In some cases you find that funds outperform the benchmark where as in some case they underperform. In such scenarios you notice that the word appears “Tracking Error”. What do you mean by this?
Tracking Error is the difference between the fund performance to benchmark returns. Suppose you invest in any mutual fund which is actually replicating NIFTY then the difference between the fund returns to NIFTY returns is called as “Tracking Error”. So what it actually indicates you?
- It shows how the fund actually replicates the Index. Whether the fund has same weighted to what Index. Closer the weightage lower will be the tracking error.
- It shows how much a fund is expensive to Index. Expenses include AUM charges, transaction costs or broker commission etc.
Now why this Tracking Error?
1) Expenses-When any mutual fund declare that it is actually reflecting the benchmark Index there consists a lot of expenses. Charges are like buying and selling of the stocks involved in a Index, day to day management charges or any fees. So in return the actual investable amount will decrease effecting in tracking error. Hence higher the expenses higher will be the tracking error and vise versa.
2) Cash balance-When you invest around Rs.10,00,000 in any such Index Funds will they invest all the so accumulated amount of all investors into buying these Index stocks? No they will not. Reason behind these is, they need to keep aside some amount in cash or in a liquid state as don’t know when investors will ask for redemption. Also when any stock held by the fund declare dividend that need to be re-invested as soon as possible to replicate the return. To make cash available to re-invest dividend they have to maintain the some % in cash or liquid state. Same is the state when fund house immediately receives a large cash from investors. Overall to meet such financial emergencies mutual fund companies maintain some % of the total corpus in cash or in a liquid state. This will decrease the total corpus required to invest in stocks of the Index. Hence larger the cash holding higher will be the tracking error and vise versa.
3) Unable to buy or sell the underlying Index stocks-Sometimes what will happen is due to sudden market upside or downside or some specific stock movement one will be unable to buy or sell the stocks when circuit breakers breaches the upper or lower bracket. This will actually imbalance the fund portfolio leading to major tracking error.
4) Effect of corporate actions-Sometimes companies which stocks are in the Index may announce some corporate actions such as a merger, debenture or warrant actions, bonus share allocation or preferential shares. In such scenario to match with Index, fund manager need to either buy or sell the stocks. This again leads to higher expenses. Also sometime during company’s amalgamation some company’s who’s stock represent Index may issue the shares of a new company which may not be the constituent of the Index. This leads to the mismatch in Index replication and holding pattern. Again this effect into increase in transaction cost of the fund.
5) Trading efficiency-Even though from investors point of view one may say no extraordinary activity required for fund managers in replicating the Index. But back end strategy of fund managers will judge this actual tracking error. Some of them are cash maintenance or dividends re-investment and position re-alignment. Hence human efficiency also matters more in maintaining minimum tracking error of the fund to some extent.