Jargon Buster. Tracking error

The variation in returns between the fund and its corresponding benchmark, usually a market index, is referred to as tracking error (TE). Given that tracking error gives investors a sense of how volatile the portfolio is relative to its benchmark, it is primarily reported by index funds.

Put simply, TE can be calculated by subtracting the fund’s returns from the return of the index it is supposed to track. But tracking error is all about variability and geeks measure this through standard deviation. So for the statistically inclined, TE is the standard deviation of the difference between the returns of the fund and its corresponding benchmark.

An index mutual fund is a passive investment vehicle benchmarked to popular stock market indices such as S&P BSE Sensex.

The fund invests in securities in the same proportion or weightage as they occur in the index. When comparing returns, it is incorrect to consider the plain vanilla prices of the indices alone. Why? Because dividends declared by companies also make a significant difference to returns over the long run. While dividend payouts are factored in the NAVs of funds, most benchmark indices' returns are calculated without considering the impact of dividends. Hence, you need to compare the total return index (TRI) disseminated by the stock exchanges on their indices. This index captures the effective returns on the base index if the dividends paid by the constituent companies were re-invested in the index. If the returns of the fund are closer to its benchmark, then it can imply that TE is lower and vice-versa.

Why does it occur? As index funds are slaves to their benchmark, the role of the fund manager in seeking scheme-beating returns is significantly curtailed. The fund’s mandate defines the portfolio construct and, therefore, in theory the scheme and benchmark are expected to move in unison.

However, factors such as change in the index constituents, cash holdings, expense ratio and extreme volatility can impact TE.

For instance, consider that an announcement is made by the stock exchange of a reconstitution of its index in the next 30 days. Based on this news, the stock that is being moved out can immediately shed value and the one that is being added to the index normally trades in the green. The fund manager however cannot immediately realign the fund’s portfolio. Only after the official reconstitution takes effect can the change be made.

In addition, the fund manager has to contend with both inflows and outflows, based on which the fund manager may have to buy or sell securities. Such activity can add to expenses such as brokerage pulling down returns, contributing to TE.

Also, the fund may hold on to some cash. If this cash is not invested, it can not only be a drag on returns, but can affect TE as well.

Indian experience Unlike western countries, passive funds are not a rage in India. But most mutual funds do offer a scheme or two.

Let us consider the returns of HDFC Index Fund SENSEX Plan, benchmarked to S&P BSE SENSEX (Total Returns Index). For the fiscal year 2015-16, the scheme lost 7.96 per cent while its benchmark lost 7.91 per cent, a difference of 0.05 per cent. The fund reported an annualised TE of 0.33 per cent, which is low, implying that the fund closely tracks its benchmark.

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