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Tracking Error : Under the Lens

Tracking error tells us how much an index fund's returns deviate from that of the benchmark index. Lower the tracking error the better the fund is performing.

An Index Fund is just about the simplest kind of fund there can be. All that its managers have to do is to mimic a market index, making sure that the fund has exactly the same hold-ings in exactly the same proportions as the index on which it is based. This process of mimicking an index, however, is not perfect. There are a number of factors that may make the fund's holdings, and therefore retu-rns, deviate from being exactly the same as the index.

'Tracking Error' is a measure of such deviations. It tells us how much an index fund's returns deviate from the benchmark index's returns over any given period of time. Since an index fund is supposed to provide the same returns as the index, tracking error is a good way of measuring how well an index fund is run. A well-run index fund will generally have a small tracking error.
Calculating tracking error is simple. It is the standard deviation of the difference between a fund's daily return (in percentage term) and the benchmark index.
However, you must be wondering as to what gives rise to a tracking error, after all, an index fund passively purchases all the stocks of a market index, in exact proportion. There are three major reasons for this - expenses, idle cash, and an inability to match the fund's portfolio exactly to the index.

This inability could arise from large orders by the fund itself that could impact stock prices. There could be delays in putting new investments to work, or discrepancies that arise from holdings sold to meet redemption.
Large buy or sell orders by such funds could result in volatile movements in stock prices in turn affecting the fund performance. Plus, the fund has to invest new funds and meet redemption when investors cash out. How well a fund handles these processes affect how closely it tracks the index.

In recent years tracking errors have come down drastically due to more flexibility in trading. For example, odd lots have ceased to be a factor. Also, with the introduction of dematerialised shares and online trading, delays arising from the physical transfer of shares have vanished.

While you may expect an index fund to return more than an index occasionally, this is rare because the expenses of the fund are always a strong negative factor.

Tracking Errors of Indian Index Funds
  Nifty Trackers  Launch Date  Tracking Error*
  IDBI Principal Index Fund Jun-99 0.11
  UTI Nifty Index Fund Mar-00 0.14
  Franklin India Index Fund Jul-00 0.11
  SBI Magnum Index Fund Jan-02 0.29
  Franklin India Index Tax Fund Feb-02 0.15
  IL&FS Index Fund Nifty Feb-02 1.51
  Prudential ICICI Index Fund Feb-02 0.32
  FT India Index Fund Nifty Aug-02 0.23
  Nifty BeES Dec-02 0.25
  Sensex Trackers  
  UTI Master Index Fund Jun-98 0.13
  FT India Index Fund Sensex Aug-02 0.23
  IL&FS Index Fund Sensex Feb-02 0.81
* Annualised % since launch

    Curiously, the tracking errors of many well-managed index funds in the US tend to be smaller than their expense ratios. This actually means that their fund managers have worked the apparent miracle of consistently staying slightly above their benchmarks. Perhaps as this class of funds mature, Indian fund managers will also learn this valuable trick.

Foreign Index Funds: A Sampler
  Index Fund  Net Assets   Tracking
   (Million US$) Error (%)
  Morgan Stanley S&P 500 Index-A 1991.9 0.041
  Scudder S&P 500 Index Fd-AA 879.86 0.071
  Vanguard 500 Index Fund-Inv 86298.83 0.078
  Dreyfus Basic S&P 500 Stock I 1122.79 0.092
  Merrill Lynch S&P 500 Index-D 1745.08 0.096
  Fidelity Spartan 500 Index 7102.61 0.126
  E*Trade S&P 500 Index Fund 85.3 0.153
  Invesco S&P 500 Index Fund-Inv 278.19 0.157
  Nationwide S&P 500 Index-A 498.89 0.177
  Barclays S&P 500 Stock Fund 1420.52 1.126
Source: Bloomberg