Mutual Funds-Understanding the Tracking Error

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.

 

 

21 Comments

  1. dear sir,
    I hav a querry reg Pls read the bellow statement carefully, which I got from hdfc ELSS booklet and elaborate:

    (In ELSS each installment will be subject to a three-year lock-in. So, if we enroll in a three-year SIP and invest systematically every month for three years, we will get
    your entire proceeds only after six years (after your last installment at the end of the third year completes three years).
    This means If I start today i.e 13-11-2013 my 1st installment & I opt for three years Sip then I would finish my last installment 13-11-2016 ok.
    and for my 1st installment the withdraw date according to above statement it should be
    14-11-2019. It clearly means my lock in period for 1st installment will be for six year.
    Please advice your views.

    Reply
    • Atmaram-No don’t make confuse yourself. If you start your first SIP on 13-11-2013 then this particular SIP will be eligible for withdrawal after completion of 3 years i.e. from 13-11-2016 but not 2019. Keep in mind that First In and First First Out (FIFO). If you have 3 years SIP then your last invested SIP will be eligible for withdrawal from 6 years of your start SIP.

      Reply
  2. Hello
    Wish u a very happy Deepawali for you & family
    I have a querry regarding 1st time entering into the MF and the current market as it peak (bullish)level, & as per regular expert says at this time we think of sell the stock to make good profit, anyhow it is tedency that at market down wards one should grab the stock & sell it at peak times.
    it is ok for stocks.
    my querry is
    is it same funda works on Mutual funds means if a new investor wants to enter into MF is it right time for him because if I invest at this time then I have to wait & watch for time when call more better than this to exit if not he may get nothing. and if this is right then he go by SIP method for long period is it same impact ?
    pls give clarity of what is right time to enter for new entrant Or he has to wait for how much period if not he can go SIP method to step into mf.
    If yes give the best knowledge to move ahead with a good product plan.
    and is their any controls in SIP method to invest definitely any how in regular intervals or we can manage as possible as fund requirement.

    Pls advice ASAP
    waiting to hear from u

    Reply
    • Atmaram-Thanks for your wishes and the same to you. The first thing to make you clear is, no one can time the market perfectly. So if you have a long term investment time horizon of around more than 10 years then it is always best to start soon with monthly SIP. So go ahead with investing if you are a long term investor and investing through SIP. The best method of investing will be monthly SIP. Because managing yourself will not be systematic. So opt for monthly SIP only. By investing not more than around 4-5 funds you can diversify your investment well and reap the benefits.

      Reply
      • Thank u for advicing
        as I hav planned for long term investment with SIP mode as direct means online investment then howz it works Is it will directly deduct from my account as per specified period monthly or we hav to pay as same as online premiums. or it depends on our wish to pay constant every month,can we increase or decrease in these.
        and I hav a querry regarding If I go through AMF distributor then I hav to bare his commission It indicates less profit in long term.then how to come up with this situation.
        how can we minimize ur cost & mazimize our gains.

        Pls.reply

        Reply
        • Atmaram-In SIP you have two options to invest, through post dated cheques or auto debit. In auto debit mode monthly on a specific date, you are instructing the bank to debit specified sum towards this mutual fund investment for a certain period. So in this case you are investing equal amounts monthly on a specified date. That is why the name is the SIP (Systematic Investment Plan).
          Now coming to distributor expenses, if you have expertise in choosing the funds, time to monitor those investments and taking care of future service related issue then definitely you can go ahead for direct plans. Wherein NAV will be different than normal plans (which includes the expenses of distributor). But again I am not assuring you that by opting distributor for your investment you may receive the service or not. As it depends on the quality of knowledge and service distributor provides to you. To me the best option will be to learn yourself and opt to start investing in direct plans. Because it is your money and you need to take care more than anyone else.

          Reply
          • thanks alot for your valuable suggestion
            as u said In auto debit mode monthly on a specific date, you are instructing the bank to debit specified sum towards this mutual fund investment for a certain period
            in this u hav mentioned for certain period it means If I go for long term EX 10 years period then it will debit from my account till 10 years & I hav to mentain credit bal in my account for till that period.
            for instance unfortunately happens with me & my family are unable to afford or they do not hav proper knowledge regarding this than how to handle this situation.
            and as u said post dated cheques means we have to deposit a systematic sum of amount every month without missing till the period end.& for auto Debit Is it better to open a seperate saving account or shall we link it with the salary account ?
            I hav humble request to you
            like their are more readers who want to start up with new investment for his betterment of tomorrow but lack of proper guidance,
            & whom to approach,whether he will guide us or he will misguide for his selfishness.its very dilemma in the mind at this situation. and if he tries to self learn something from outsiders but as you know the availability of abandon information outside its make more confused to opt the right one ( for ex: if we search a simple word on google it shows a n.no.of results which make him more confused to opt betterone.) than how an individual to come up with it. everybody needs a platform where he can trust an give a good start to his life.
            Request you to write an article which encourage and gives a thrust worthy guidance & a platform to follow for steping into new investment with a support when needed forever.

            thank u
            awaiting to here from you if I my request is worth-full.

            Reply
            • Atmaram-My suggestion will be to go with auto debit for 5 years only. Because if the fund not performing well then you can switch over to another fund. You have the option to stop your investment at any point of time. So no need to worry about that. I don’t think it is wise to have separate account only to invest in mutual funds. Instead you can use the same salary account for investment.

              Trust worthiness of a information you get depends on your judging capacity. So the only solution left is, start to read about mutual fund and other investment ideas. Once you find yourself that information provide will be trustworthy then you can go ahead. Because I can’t judge your level of believing others from my point. It is you who can decide. But the only panacea is to have good knowledge about personal finance. It is not the big thing, but need some constant interest towards this subject. There are plenty of guys who started to learn like you and now they are at the stage of advising others than any financial professional. So go ahead and acquire the knowledge.

              Reply
              • ok thanks
                and try to share any knowledgeable information related to this such that we can upgrade ourself.

                Reply
                • Atmaram-You can read ET Wealth of Monday’s special edition of Economic Times, subramoney blog, freefincal blog and do search wherever you find the doubts and you will find the right answer 🙂

                  Reply
                    • Dear Sir,
                      I want to know the performance of HDFC Long Term Advantage (G)
                      for long term ( expected 5 years) as sip
                      is it goood to opt the fund.
                      Advice your opinion.

                    • Atmaram-It is a tax saving fund. If you need some tax saving investment then go ahead. Lock in will be three years. It means, if you are opting for SIP then each SIP need to complete 3 years.

                  • Dear Sir,
                    I am again at your door step for your valuable suggession.
                    my qerry regarding Fundsupermart.com is one of the largest online distributors of mutual funds & they provide free service (no charges for opening or maintaining the account. It is a completely free-of-charge platform for investors) as per their web portal.
                    what is the ground reality about this is it trustful their words or any fraud or any hidden charges which they do not want to disclouse to attract new clients.
                    Is this site is registered in AMFI. then why they dont charge for their services nobody give service free of cost,then how they exist.
                    can we believe and join to start investing through this online portal.

                    awaiting for your valuable advice

                    thanks

                    Reply
                    • Atmaram-Fundsupermart, Fundsindia or any other advisory platform which may claim to be free, but in reality there will be charges which they get directly from mutual fund companies. If you go through any mutual fund investment through any middlemen then there will be three charges, for better understanding of those charges visit my post “Life Insurance Vs Mutual Fund Agents-Who earns more?“. So eventhough it seems free for you but mutual fund companies will pay to distributor and which will directly adjusted in NAVs. If you are first time investor and no need of time to track or no time for service related issue then you can opt middlemen, otherwise currently you have direct plans also wherein you will invest directly in mutual funds without any middlemen. So the charges saved will be reflcted in direct plans NAVs (which are different from other plans). You save few % from such investment. You can also view my opinion on this investment here “Mutual Fund Direct Plans-Who can move?“. Afterward you can take your call.

                      No need to worry about registration with AMFI, all are registered only. So now once again decision is yours 🙂

  3. Hello,
    first I want to Wish u a Happy Deepawali & seasonal Greetings to u & family.
    I would like to invest in MF for the first time and the current market as it peak (bullish)level, & as per expert says at this time we think of sell the stock to make good profit, anyhow it is tedency that when the at market downwards one should grab the stock & sell it at peak times.
    it is ok for stocks.
    my querry is
    is it same funda works on Mutual funds means if a new invester wants to enter into MF is it right time for him because if he invest at this time then he hav to wait & watch for time when call more better than this to exit if not he may get nothing. and if this is right then shall go by SIP method is it same impact ?
    pls give clarity of what is right time to enter for new entrant Or he has to wait for how much period if not he can go SIP method to step into mf.
    give me clarity

    awaiting to hear from you.

    Reply
  4. Thank you for information. Good article…!

    Reply
      • Dear Sir,
        I am again at your door step for your valuable suggession.
        my qerry regarding Fundsupermart.com is one of the largest online distributors of mutual funds & they provide free service (no charges for opening or maintaining the account. It is a completely free-of-charge platform for investors) as per their web portal.
        what is the ground reality about this is it trustful their words or any fraud or any hidden charges which they do not want to disclouse to attract new clients.
        Is this site is registered in AMFI. then why they dont charge for their services nobody give service free of cost,then how they exist.
        can we believe and join to start investing through this online portal.

        awaiting for your valuable advice

        thanks

        Reply

Submit a Comment

Your email address will not be published. Required fields are marked *

2 × 5 =

Share This