Level | Advanced
What do you mean by Tracking Error?

The word ‘track’ has many meanings in the dictionary. One among them is ‘follow the trail or movements of (someone or something), typically in order to find them or note their course’. Well, you would be aware that mutual fund schemes follow a benchmark, which is usually an index that is similar to the portfolio the fund is planning to build. For example, a large cap fund may select the S&P BSE Sensex as the benchmark whereas a mid-cap focused fund may choose a mid-cap index as its benchmark. The benchmark acts as the reference point to assess and evaluate the scheme’s portfolio and returns. The scheme is expected to deliver returns in line with that of the identified benchmark.

Tracking error is simply the difference between the scheme’s return and that of the benchmark. This measures how closely a mutual fund scheme replicates the returns of the identified benchmark. Larger the deviation from its benchmark returns, higher the tracking error a scheme is said to have.

Active funds and passive funds

There are schemes which simply strive to generate returns in line with their benchmark and there are those that strive to beat their benchmark. The former are typically passive schemes that simply replicate the benchmark index in their portfolio and are often constructed as index funds. As these schemes replicate the benchmark index, they are expected to give as close a return as possible to that of their benchmark. The difference between the two returns is measured as its tracking error.

A scheme that strives to beat its benchmark typically tends to build its own portfolio which may or may not have any correlation to the identified benchmark and is called as an active fund. As these funds do not intend tracking the benchmark, either in terms of portfolio construction or in returns, tracking error is less relevant to such active schemes.

Why tracking error occurs and why is it important to understand tracking error?

A passive fund is expected to deliver returns exactly as its benchmark. But in practice, there exists some deviation between the two, which is called the tracking error. The reasons for this error are:

- Expenses: The mutual fund scheme incurs expenses both in the operation of the scheme (brokerage, security transaction tax, etc.) and also in running its business (marketing, accounting, administration, etc). These need to be passed on to the scheme. This would certainly eat away a part of the scheme’s returns.

- Portfolio deviation: It could so happen that the scheme does not replicate the benchmark portfolio as accurately as it should. This would automatically lead to differences in returns.

- Dividends: A passive mutual fund scheme reinvests the dividends that it receives from the securities it holds. But most index values do not reflect the dividend paid out by its constituents. This dividend would create deviation between the scheme returns and index returns. If however, the benchmark is a Total Returns Index (TRI) which accounts for the reinvestment of the dividends, the deviation is likely to be minimal.

How to measure tracking error?

There are two methods in which tracking error can be calculated. These are:

1. Simple arithmetic subtraction: In this you need to simply subtract the scheme’s return from that of the benchmark over the relevant period. For example, if the scheme has returned 9 per cent over the past year whereas its benchmark has returned 10 per cent, the tracking error is simply 1 per cent (10%-9%).

2. Computing the standard deviation: In this method, you would need to find the standard deviation of the differences between the scheme’s returns and that of its benchmark, over different time periods. For example, let’s say Scheme A had these deviations over its benchmark returns over the last 5 years:

Year 1 0.83
Year 2 0.56
Year 3 1.07
Year 4 0.96
Year 5 0.83

The standard deviation of the above works out to 0.19^ which is the tracking error of the scheme over the five-year period.

In conclusion, understanding tracking error becomes important because you need to know whether a scheme is returning close to its benchmark and why is there a variation.

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Key Takeaways

  1. Every scheme has a benchmark index for performance evaluation.
  2. Tracking error is the deviation of the scheme’s return from that of its benchmark index.
  3. Tracking error is more relevant to passive funds than active funds.
  4. There are two methods of calculating tracking error - simple arithmetic subtraction and standard deviation.