Of tracking error and tracking difference

Passive funds follow a rule-based approach to investing with no active stock selection. They follow an index (like Nifty 50 or Nifty 500) and try to replicate its performance by buying all stocks with the same weight as in the index. In the replication process, several practical challenges can prevent the fund from achieving the same return as the benchmark, resulting in a slight deviation. These deviations in the returns are measured in terms of tracking difference (TD) and tracking error (TE).

TD is the difference between the fund return and benchmark return. Suppose the benchmark Nifty 50 Index has returned 12% in one year and the Nifty 50 Index Fund has given 11% returns in the same period. The tracking difference is the 1% deviation in returns. Due to Total Expense Ratio (TER) and other expenses, TD is almost always negative. Any fund with a relatively higher TD (either negative or positive) should be generally avoided. Higher TD exhibits potentially less efficient fund management.

One of the drawbacks of TD is that it compares point-to-point numbers to determine fund management efficiency. To see how the fund is managed throughout the period, TE is used. Frequent movements in daily tracking difference over a period causes higher TE. It is the variability (or volatility) of daily tracking difference, a statistical term measured as the standard deviation of daily tracking difference. Avoiding jargons, if an investor is comparing multiple index funds tracking the same index, he can follow this thumb rule: the lower the TE, the more efficiently a fund tracks the index.

Things get interesting when we combine TD and TE. Ideally, both should be lower and examined in tandem to evaluate the fund performance. While evaluating the performance of different schemes tracking the same index, investors should select the fund which has consistently delivered the lowest tracking error and tracking difference. But, it’s important to note that a fund could exhibit a high tracking error and still outperform its peers. To select an efficiently managed fund, investors must not solely rely on one parameter; rather they should consider both the parameters to draw a meaningful conclusion.

Solely focusing on tracking error or tracking difference can be misleading as a fund with a higher tracking error doesn’t necessarily indicate inefficient index tracking and vice versa.

But why does the fund deviate from the benchmark returns? It is practically impossible for a fund manager to achieve the same returns as the index. A fund manager faces several practical challenges that deviate the scheme return from the benchmark return, such as:

Expenses: Passive funds charge TER to cover management and operating expenses associated with managing the fund. A higher or lower TER has a direct impact on the fund returns.

Cash holdings: Passive funds also hold a certain percentage of AUM in cash and cash equivalents (usually liquid securities) to honour investor redemptions. Since this amount is not invested, it may drag or add to the fund returns in rising or falling markets.

Securities lending: Passive funds may also have a source of revenue over and above the returns of the index. They can lend securities held by them to other market participants for a limited period in exchange for a fee. The additional revenue generally helps reduce costs and improve tracking difference.

Execution timing: Several stocks get added or removed during an index rebalance. While the index uses closing day prices for return calculation, in reality, fund managers may not be able to execute transactions exactly at the closing prices. This causes a slight mismatch in the execution price, causing tracking difference. This is also applicable for daily investor’s cash flow management.

Delay in receipt of dividend: When a fund receives dividends from the underlying securities, there is a timing difference between when the fund receives the payout and when the benchmark index accounts for those payments, which might add to the tracking difference.

Other costs: Passive funds also incur other expenses like goods and services tax on management fees, brokerage fees for buy and sell transactions, exit load expenses, etc., which also impact fund returns. Apart from these, several factors such as corporate actions (stock splits, mergers and acquisitions, spin-offs, etc.) also cause tracking differences.

Mahavir Kaswa is head of research, passive funds, Motilal Oswal AMC.

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