The Hindu Business Line : Tracking error of index funds widens

Mumbai, Aug. 8 Tracking error of index funds has been widening as the market turned extremely volatile in 2008. Eight funds out of the 22 had a tracking error (in the last one-year period) of more than 2 at the end of June 2008, according to Value Research data.

Tracking error measures the standard deviation of the difference between the portfolio and index returns.

In simple terms, the tracking error is the difference between returns from the index fund to that of the index. Lower the tracking error, closer are the returns of the fund to that of the target index.

Tracking error showed a marked-rise on index funds compared with December 31, 2007, data.

Deviation

“The tracking error is in a way a measure of how much a fund manager is deviating from the objective of the fund,” said Mr Rajan Mehta, Executive Director, Benchmark Mutual Fund.

Funds such as Birla Sun Life Index, HDFC Index Nifty, HDFC Index Sensex, ICICI Prudential Index, ICICI Prudential SPIcE, LICMF Index Nifty, LICMF Index Sensex and Magnum Index have tracking errors of more than 2 for one-year tracking error data ending July 2008, according to Value Research.

“Good index funds are those which have a low tracking error preferably below one per cent,” said Mr Krishnan Sitaram, Head of Crisil Fund Services, Crisil. The higher tracking error actually suggests that the fund manager took on greater risk.

Transaction costs

Many index funds have a very low asset base, so when there is a lot of selling and buying happening, the transaction costs go up and this is one reason for the tracking error to go up; and there is also operational inconvenience to blame, added Mr Sitaram.

Another reason is when the fund houses hold higher cash to meet redemption pressure, he added.

According to the data on the six-month tracking error of index funds, ending July 2008, the tracking errors mutual funds are higher than 10, with LICMF Index Sensex with a tracking error of 10.54, PSU Bank BeES of 25.43, Kotak PSU Bank ETF of 25.63.

In India, index funds have never been very popular, in fact, in a bull run, investors prefer actively-managed funds rather than passively-managed funds, said a fund manager.

Time Lag

According to an analyst, investors want returns linked closely to the index and tracking error indicates that there is a deviation from that which wholly goes against the concept of the index funds. One reason for tracking errors to happen is also that money comes in at different times so there is a lag between fund flows and the execution (to buy stocks), he added.

But going forward with the direct market access technology, it would be better and faster to execute and operate such funds, said the fund manager of a mutual fund house. If an index fund has an exposure to derivatives in that case also the tracking error goes up to the extent of the fluctuation in the future’s value, an equity fund manager with domestic asset management company said.

An index fund is a mutual fund scheme that invests in the securities in the target index in the same proportion or weightage of the securities as it bears to the target index. An investment manager attempts to replicate the investment results of the target index by holding all the securities in the index.