There has been a long waiting request from some of the readers about Index Funds and exchange traded funds (ETF), on how to gauge their performance with respect to the Index they are tracking.
In this article, I’ll present the details on how one can check whether the Index Fund of ETF is exactly tracking the index, and most importantly, how tracking error works.
As I’ve explained in my previous articles Index Fund v/s ETF, Index fund and ETF differ in the way they are traded. ETF can be bought as a single stock, while IF can be bought only as Mutual fund units.
Both ETF and IF try to follow one of the available market indices – it can be DowJones, NASDAQ, NIFTY, Sensex, etc. Sector specific funds like UTI Infrastructure fund will be trying to follow the Infrastructure Index, while a Index fund based upon investments primarily in Banking sector may follow BSE Bankex Index. Ultimately, every single fund that exists in the market follows an index, and this index is known as its BENCHMARK index.
Why a fund needs a Benchmark index?
A fund needs to show how well it performing, to attract the investors. The simplest way for a fund to do so is by comparing itself against an already existing market index. Hence, let’s say there is an Index fund based on Sensex or Dowjones Index. If, at the end of a year, an investor wants to see how has the Index fund performed, he can simply compare the returns from the Sensex or Dowjones, to that generated by the Index fund. This gives them a benchmark to gauge the performance of the fund.
How to check for the Index Fund follow up with the benchmark Index
That’s where the “tracking error” concept comes into picture. The simplest and the most basic definition of tracking error is that it is defined as the difference in returns between fund (portfolio) and benchmark index.
Continue to Part II
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