Tracking Errors in Index Funds – II

This is part II of the article Tracking Errors in Index Funds –Part I. Please read the article from Part I, before continuing with this part.

An example, let’s say you invested in XYZ Index fund that is tracking Dowjones Index. Suppose your XYZ Index fund returns 12%, while Dowjones returns are 15%. Hence the tracking error for the XYZ fund becomes -3% with respect to its benchmark index.

In essence, the “tracking error” tries to track the performance of a Fund with respect to its benchmark index. It is not only an indication of the performance of the fund with respect to its benchmark index, but also a sign of how much risk is their in the fund. Continuing the example mentioned above, the fund is having a tracking error of -3%, which shows that it has performed worse that the benchmark. Also, the risk is high; 3% with respect to the index return of 15% is actually 20%. Hence, there is a 20% more risk involved in this index fund, with respect to the benchmark.

Now, why should we care about the tacking error?

It’s true that it is based upon historical data, which does not guarantee anything for the future. But actually, Tracking error can be quite useful to observe how your fund manager is playing around with your money, how is his investment pattern and what kind of risk taker he is.

Whenever there is a new fund introduced, it has to declare its investment pattern and style. Say the offer document of an index fund says that the fund will track Sensex, and its tracking error is showing consistent deviation from the Sensex, that means that fund manager is not actually able to keep up his promised investment style. He is either deviating from his investment pattern declared in the offer document, or is paying/taking extra commission or transaction charges which are hampering the performance of your invested money.


Why does this error come in?
The main reasons why tracking error values are high are as follows:

1. High Transaction costs and commissions: They eat up the return on your invested money

2. Time log of tracking the benchmark index: Benchmark Index changes its value every second. The fund manager should churn his portfolio so as to exactly replicate the benchmark index constituents, as explained in my previous article. However, the problem is that frequent change in portfolio incurs lots of transaction costs. Hence, portfolio changes can be done only once in a while. This is the major reason for tracking errors

3. Change in Benchmark constituents: Another reason for tracking error. Primarily, a new entrant into the Benchmark index becomes very costly by the time the fund manager buys it. While an outgoing stock becomes very cheap by the time he sells it. As a result, low returns, hence a big tracking error.

Ultimately, the fund manager cannot track any underlying index to the point. Though he tries to claim that he is tracking a particular index, he will never be able to meet its performance because of transaction costs. Hence, ultimately he starts to deviate from the benchmark index constituents. That is what leads to the tracking error.

So choice is yours! Realize the truth that fund managers cannot replicate the index exactly. They end up gambling with your money based upon the beliefs that they can outsmart the index. The result are as shown in the graph of the article Should you trust your fund manager?

Please read the comments and post your views and queries in the comments section which helps in open discussion and avoids duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.