Tracking error of index funds
Index Mutual Fund follows the particular Benchmark index from the Stock Market. They passively invest in these indices. Index Mutual funds are the replica of the Benchmark Index. Index Mutual Fund should give
returns like that of its Benchmark Index. But in practice, this won’t happen. There are deviations between the performance of the Benchmark Index and Index Mutual Fund. This difference or deviation is because
of the Tracking Error.
returns like that of its Benchmark Index. But in practice, this won’t happen. There are deviations between the performance of the Benchmark Index and Index Mutual Fund. This difference or deviation is because
of the Tracking Error.
 |
Tracking Error of Index Funds directly impacts the returns of Index Funds. Greater Tracking Errors in Index Funds will reduce the returns of investors. Lesser tracking errors will naturally increase the returns for investors.
What is Tracking Error (Tracking Error Formula)
Before understanding how to calculate Trading Error, we have to understand the term Tracking Difference. We will try to understand the Tracking Difference by taking the below example. Please consider the data in the below chart.
|
Year |
Index |
Index |
Tracking |
|
2000 |
10 |
11 |
-1 |
|
2001 |
12 |
11 |
1 |
|
2002 |
11 |
10 |
1 |
|
2003 |
8 |
9 |
-1 |
|
2004 |
10 |
12 |
-2 |
Tracking difference is the difference between the returns of an Index Fund and its benchmark index. Tracking Error is the standard deviation of Tracking differences of each year. There is no need to worry about the calculation of standard deviation. You can easily calculate it by entering data in MS Excel and using the Excel function STDEV(Data range).
=STDEV(A1:A5)
This Standard deviation will be a Tracking Error in Mutual Fund. In the above example, the Tracking Error is 1.34. Low tracking error indicates that the Index fund is giving returns near to its benchmark index. High tracking error indicates that there are weak co-relations between the Benchmark Index and Mutual fund.
What are the reasons for tracking error?
There are many reasons for causing tracking errors in Mutual Funds.
1… There is a difference in the composition of the Benchmark Index and Index Mutual Fund. Mutual fund Houses never invest 100% of their AUM money in index. They prefer to keep some money in cash which can be used by them in case of redemption of Mutual Funds. This causes the Tracking Error.
2.. Index Mutual Funds are cost-effective as minimum managerial intervention is required to manage the fund. But there are some unavoidable costs like commission on selling and purchase of stocks. It can increase the expenses of an Index Mutual Fund. This can increase Tracking Error. Sometimes Index mutual funds cannot buy and sell some stocks because of Liquidity issued in those stocks. That can also lead to tracking errors.
Conclusion: –
Tracking errors in Index Mutual Funds directly impact the returns of Mutual funds. Higher tracking errors will reduce the return of investors. Similarly, Index Mutual funds having fewer tracking errors will deliver higher
returns. Mutual Fund houses cannot completely remove the Tracking error. Tracking error exists in most Index Mutual Funds.
returns. Mutual Fund houses cannot completely remove the Tracking error. Tracking error exists in most Index Mutual Funds.
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