Mutual Fund Unlocked: Tracking Error

Tracking error is a measure to analyse index funds. The basic premise of investing into index funds is to achieve the returns which are commensurate to that of the targeted benchmark Index. An Index Fund is a mutual fund scheme that invests in the stocks which constitute benchmark index by replicating the weightage given to the securities on the benchmark.

A Fund manager tries to achieve the investment outcomes of the target index by holding all the securities in the benchmark. Beside this there are still some reasons like higher expenditure, cash balance that lead to discrepancy between the returns of the benchmark and that of the fund. This difference in the returns of the fund with its respective benchmark is known as Tracking Error.

Tracking error is nothing but a standard deviation of the differential returns. Differential returns are defined as the difference between the index return and fund returns. So, tracking error evaluates the extent to which the differential returns differs from the average differential return.

Reasons For the tracking Error

Expenditure

The fund incurs expenses like transaction fees for purchase securities, sale of securities which lead to differential returns. As these expenses gets subtracted from the returns of the fund. Higher expenses lead to higher tracking error. Vice versa lower the expenditure incurred by the mutual fund scheme, the lower will be the tracking error.

Cash Balance

In an ideal world, the full corpus of the fund is expected to be invested in the underlying securities. But this is not possible owing to the funds obligation to meet redemption and expenses incurred. So, when the mutual fund scheme holds excess cash, it has that much lesser amount to invest in the underlying benchmark which leads to mismatch in the returns.

Tracking Error is one of the key aspect to look for before choosing an index fund for investment. Funds with lower tracking error are expected to provide returns in-line with the benchmark indices as they nearly follow the benchmark index's movement. However, if an index fund shows high tracking error compared with other similar index funds, it suggests that the fund is not following its stated objectives.

Mutual Fund Unlocked: Basics of Mutual Funds (Part I)