Does Tracking Error Matter in Index Funds?

Are you looking for a passive investment to attain your long term financial goals? Do you want returns that match the stock market? You can invest in Index Funds. It is a passive mutual fund that tracks and replicates a stock market index portfolio such as the Nifty 50 and the BSE Sensex. Moreover, investing in index funds helps you get returns that match the stock market. Index funds are vulnerable to tracking errors. Let’s understand what tracking error is and if it impacts your returns from index funds.

What is a tracking error in Index Funds?

A passive investment like index funds attempts to mimic a stock market index portfolio. However, its returns do not ideally mimic the index because of mutual fund expenses or issues with buying and selling index stocks. 

It leads to tracking error which is the difference between the index funds return and those of the benchmark index it follows. Suppose the BSE Sensex gained 4% this month. The Net Asset Value (NAV) of an index fund tracking the BSE Sensex gained 3.5% during the same period. The difference of 0.5% (4%-3.5%) is the tracking error of the index fund. 

Tracking error shows how well an index fund tracks the benchmark index during the investment period. For instance, a small tracking error means the index fund follows its benchmark index closely, whereas a higher tracking error shows the opposite.

Does tracking error matter in index funds?

You must check the tracking error of index funds rather than fund returns. It helps to pick an index fund with a lower tracking error to minimise the deviation in return from the benchmark index. 

Tracking error helps you gauge the index fund’s risk level and how well the fund is being managed. You must study the tracking error of the index fund over a few quarters. 

It helps you understand if the index fund is taking unnecessary risks by holding high cash levels or maintaining a lopsided index weightage. 

One of the main reasons for a higher tracking error for index funds is its expense ratio. A higher expense ratio, the cost of managing the fund, eats up your returns over time. In simple terms, if an index fund has a higher expense ratio, it could increase the index funds tracking error. 

How to pick index funds with a lower tracking error?

It would help assign a higher weightage to index funds whose tracking error is below the average of other index funds tracking the same benchmark.

It helps avoid committing your investment towards index funds with the lowest tracking error rather than picking funds with a lower-than-average tracking error. 

Many AMCs have launched index funds through New Fund Offers or NFOs. However, these index funds do not have a track record of performance, and you cannot determine their tracking error. It makes sense to check the performance of these new index funds over time and invest if they have a lower tracking error. 

Many new-age AMCs and some older ones offer index funds at lower expense ratios to attract passive fund investors. It has fueled competition among AMCs to reduce index funds expense ratios further. It helps investors invest in index funds with a lower tracking error. In a nutshell, you must select index funds with a lower tracking error rather than focus only on returns.

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