Never before have index funds been so off-the-track when compared to their benchmark. Though index funds come packaged with some amount of tracking error, a deviation that nears two digits deserves some sort of a scrutiny.
The tracking error is the difference between returns of the index and the fund. Generally speaking, the less of it, the better. But we noticed that it has become more pronounced in the recent past. For example, in its three-month return, LIC MF Index Sensex, which is benchmarked against the Sensex, tops the list of funds with the highest tracking error in all the time horizons. The tracking error for LICMF Index Sensex is as high as 9.38 per cent for the three-month category and 10.54 per cent for the six-month category. For the one-year and two-year category the error is somewhat less, but still glaring, at 7.53 per cent and 5.74 per cent, respectively. Same is the case with ICICI Prudential Index, which is benchmarked against CNX Nifty. The tracking error for the fund is much less when compared to LICMF, but still at a higher side at 3.19 per cent for three months and 2.91 per cent for six months.
Remember, a tracking error will only tell you the deviation and not the relative performance. Consider LICMF Index Sensex. If you had not known that the Sensex fell by 16.96 per cent in the last three months, you might have just assumed that the fund's fall of 20.92 per cent was in line with the Sensex fall. But that has not been the case at all. The difference could arise due to various reasons. One being the difference in weightages assigned to companies. For example, Tata Steel comprises 3.11 per cent of the Sensex. But in LIC MF Index Sensex, it is 4.39 per cent. Infosys has a weightage of 9.10 in the fund but only 7.91 in the index. Ditto is the case with cash levels. While the LIC fund is fully invested in this market, SBI's Magnum fund has 10 per cent and 2.07 per cent of net assets in cash and term deposits, respectively. Birla Sun Life Index has 25 per cent of its net assets in cash. Holding cash in an index fund is a double edged sword. If the benchmark scrips go up, the fund will lose out on returns. But if the scrips go down, the fund will fall less as compared to the benchmark.
Add to it, we have ICICI Prudential Index Fund, which has graduated to a new level by allowing for an exposure to derivatives. ICICI Prudential Index fund is the only index fund that had a 16 per cent exposure to Nifty Futures at the end of July 2008. By using index and even stock futures, ICICI Prudential Index has given some sort of respite to its investors. Over six months, while the Nifty has fallen 15.66 per cent, the fund has fallen 14.18 per cent and over one year, while the index has fallen by 4.33 per cent, the fund has fallen by just 2.33 per cent.
On one hand, there has been an increased endeavour by index fund managers to try and insulate investors in such a falling market by taking advantage of strategies within their mandate. In itself, this is a good move. But by doing this they have rendered the passively managed approach of index funds meaningless. And if they resort to derivatives trading, they are no longer passively managed but actively managed ones which expect to make money (and lose less), not just match the benchmark.