Understanding Tracking Error of Index Fund and Exchange Traded Fund (ETF)

Cost and Tracking Error are two major evaluation factors when it comes to choosing any passive fund i.e. either index fund and/or Exchange Traded Fund (ETFs). In this post we are going to discuss about tracking errors.

The job of any index fund and ETF is to track its underlying asset or index as closely as possible. Further, it has to provide the returns that are provided by the total return index.

Total return index is an index which also accounts for dividends etc. E.g. as on February 28, 2017 closing value of Nifty 50 Index was 8,879.60 where as closing value of Nifty 50 Total Return Index was 11,990.44. Similarly, closing value of S&P BSE Sensex Index was 28743.32 where as closing value of S&P BSE Sensex Total Return Index was 40,487.70. This difference is due to effect of dividend received from the stocks which are part of index & reinvestment of dividends back into an Index. You can check performance of few total return indices here.

Any deviation of returns of index fund or ETF from the returns of underlying total return index is known as tracking error. i.e. how much returns of a fund is deviating from return of underlying total return index.

Tracking error is generated majorly due to three factors;

  1. Expense ratio charged to the fund i.e. cost of the fund
  2. Efficiency of the manager of the fund
  3. Size of the fund

Let us look at each of these factors one by one.

Expense ratio charged to the fund i.e. cost of the fund

As commonly known index funds and ETFs are generally cheaper as compared to actively managed funds. However, passive funds are not free of costs. It also incurs running expenses and also need to generate some profit for its manufactures i.e. AMC. Due to this cost, which will be taken out from the fund to that extent it will provide less return as compared to its underlying index. E.g. suppose an Index Fund is charging annual 1% of the costs to fund, in such case if underling index have given 15% return in one year, the fund will give 14% return.

Efficiency of the manager of the fund

Generally it is assumed that fund manager does not have any role to play while managing passive funds, which is certainly not true. In case of passive funds, job of a fund manager is to manage corporate actions of underlying stocks, re-balancing of portfolio whenever there is any change in underlying index, maintaining cash position etc., in the fund and tracking the index as closely as possible.

  • Corporate actions: If fund received any dividend from underlying stocks it has to be efficiently re-invested. If there is right issue or any other similar corporate actions, a fund managers has to accordingly adjust the portfolio so that fund does not deviate much from its underlying index.
  • Re-balancing: Whenever there is any change in the index i.e. if new stock is getting added and old stock is going out of the index, fund manager has to efficiently buy incoming stocks and sell out going stocks, so that fund do not incur much impact.

Efficiency of a fund manager plays a crucial role in managing the tracking error.

Size of the fund

Size of the fund also matters while managing the tracking error. Lets us take the example of two funds A & B. Suppose fund A has asset under management (AUM) of Rs. 1000 Cr. and fund B has AUM of Rs. 100 Cr. Whenever there is any inflow or outflow in to these funds, fund manager has to buy or sell underlying stocks. Such transactions incur some cost like brokerage and STT. This cost is born by the entire fund. Suppose there is a cost of Rs. 1 Lakh (depending upon quantum of flow. Check here the typical cost in this article) which will be spread across the fund. Obviously, this cost of Rs. 1 Lakh will have more impact on a fund size of Rs. 100 Cr. as compared to fund size of Rs. 1000 Cr.

In case of traditional Index Fund, this cost is borne by the fund where as in case of ETFs, this cost is recovered from respective investors. Thus ETFs will have less impact of such transactions cost as compared to Index Funds. However, at the time of re-balancing when fund manager has to buy or sell the stocks, in case of ETFs also such cost is borne by the entire fund which will generate the tracking error.

Evaluating and comparing tracking errors while selecting a fund

Depending upon cost and efficiency of fund management, fund may generate positive or negative tracking error. If a fund is giving more return as compared to its underlying total return index, fund is said to have positive tracking error and vice-versa.

It is better if fund is consistently generating positive tracking error.

You may check and compare tracking error and returns of various Nifty 50 and S&P BSE Sensex based passive funds’ on this page – http://passivefunds.in/indian-etfs-index-funds-data/

Happy Indexing!