Mutual Funds’ Investments

Tracking error measures the difference between the returns of a portfolio (like a mutual fund or ETF) and its benchmark index. It quantifies how closely a portfolio replicates or "tracks" the benchmark it aims to follow.

For instance, if a fund is designed to mimic the Nifty 50 Index, tracking error shows how much the fund's performance deviates from the Nifty 50.

Meaning of Tracking Error

At its core, tracking error is the standard deviation of the difference between a portfolio’s returns and its benchmark’s returns over a specific period. It is expressed as a percentage.

• High Tracking Error: Indicates significant deviations from the benchmark. Often seen in actively managed funds.
• Low Tracking Error:Suggests the portfolio closely follows the benchmark. Common in index funds or ETFs.

Tracking error is also known as "active risk," especially in active portfolio management, where the goal is to outperform the benchmark.

How Tracking Error Works

There are 2 ways to calculate the tracking error of index funds in India. The formula is: -

1. Tracking error= Return (P) - Return (i)
   Where P=Portofolio
   i=Index or benchmark
2. Tracking error= Standard Deviation of (P-B)
   Where P=Portfolio returns
   B=Benchmark returns

Utility of Tracking Error

1. Performance EvaluationHelps investors evaluate how well a portfolio manager is replicating or outperforming the benchmark
2. Risk Assessment: Offers insights into the consistency of returns relative to the benchmark.
3. Decision-Making Tool: Investors can choose funds based on their tolerance for deviation. For instance
   • Low-risk investors prefer funds with low tracking error.
   • High-risk investorsmight be comfortable with higher tracking error in search of higher returns.

Benefits of Tracking Error

1. Transparency: Provides a clear metric to assess a fund’s adherence to its stated strategy.
2. Benchmarking: Helps investors compare multiple funds aiming to replicate the same index.
3. Risk Management: Alerts investors to potential misalignment with investment objectives.
4. Customization: Allows portfolio managers to fine-tune strategies based on desired risk levels.

Key Features of Tracking Error

1. Measure of Consistency: Indicates how reliably a fund tracks its benchmark.
2. Focus on Relative Risk: Highlights deviations rather than absolute performance.
3. Dynamic Metric: Changes with market conditions, portfolio adjustments, or benchmark alterations.
4. Applicable Across Assets: Can be used for equity funds, bond funds, or multi-asset portfolios.

Examples of Tracking Error

• Scenario:Nifty 50 ETF reports an annual return of 9.8%, while the Nifty 50 Index itself reports 10%.
• Calculation:
  • Differences: (9.8%−10%)=−0.2%
  • Tracking error is close to 0.2%,