A look at factors that influence the tracking error

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Although the demand for index funds and exchange-traded funds (ETFs) witnessed a spike during covid-19, very few investors are well versed with the technicalities of the index funds. As a mutual fund investor, you would have come across the word tracking error. Further, you must probably be aware that mutual fund schemes are measured against a benchmark, typically an index comparable to the portfolio the fund intends to develop.

For instance, a large-cap fund may use the S&P BSE Sensex as its benchmark, whereas a mid-size fund may use a mid-cap market index. The benchmark serves as a point of reference for assessing and evaluating the portfolio and returns of the scheme. The scheme is expected to generate returns comparable to the benchmark.

That said, the tracking error is just the difference in return between the scheme and the benchmark. This metric indicates the degree to which a mutual fund strategy matches the returns of a specific benchmark. The greater a scheme’s difference from its benchmark returns, the greater its tracking error is considered to be. One pertinent question is to ask what the factors that influence tracking error are? Well, let’s take a look at what are the several factors that influence the tracking error:

Factors that influence tracking error

— Bidding ETFs’ market prices above or below their net asset value (NAV) results in discounts or premiums, resulting in a more significant divergence of tracking error.

— Cash positions play a role in ETFs due to the considerable time lag between receiving and reinvesting cash. This results in tracking error variance.

— Without increasing their pricing, ETF providers cannot purchase thinly traded stocks on the benchmark. This is why they utilise samples of more liquid stocks as a proxy for the index.

— ETFs must track changes in the index. Generally, an ETF portfolio will incur transaction costs during an update that can lead to divergence of tracking error.

— A high expense ratio has a detrimental effect on the performance of ETF funds.

— Illiquid securities and volatility of the benchmark also impacts the tracking error.

Why investors should know about tracking error

— Tracking error enables the measurement and comparison of a portfolio’s performance against a specified benchmark or index.

— Allows for the assessment of the consistency of excessive returns.

— It enables the difference between an investment portfolio and a particular benchmark to be converted to a single-digit number for easier comparison and comprehension.

— It enables portfolio managers to determine the portfolio’s proximity to the benchmark.

— Error tracking acts as a checkpoint and enables portfolio managers to make informed decisions.

— It assists investors in determining the significance of discrepancies in benchmark and portfolio results.

— Additionally, it assists in determining the degree to which a portfolio manager’s investing approach is active and proficient.