An RTI query on the delay in Indian Railways’ passenger and express trains revealed that Indian passengers collectively lost 24 years in a span of 7 months from April to October 2022 due to train delays. This sheds light on the challenges we face while commuting from home to work, such as before time or delayed trains, road traffic, vehicle breakdowns, etc. These hurdles often cause deviations from our ideal travel time, which can be occasional or consistent, leading to undesired outcomes. Interestingly, a similar phenomenon occurs in the world of investing, particularly in passive funds.
But what are passive funds? Passive funds follow a rule-based approach to investing with no active stock selection. They follow an index (like Nifty 50 or Nifty 500) & try to replicate its performance by buying all stocks with the same weight as in the index. In the replication process, several practical challenges can prevent the fund from achieving the same return as the benchmark resulting in a slight deviation. These deviations in the returns are measured in terms of tracking difference & tracking error.
Tracking Difference (TD):
Tracking difference is the difference between the fund return & benchmark return. E.g., suppose the Nifty 50 Index (Benchmark) has returned 12% in 1 year & a Nifty 50 Index Fund (Fund) has 11% returns in the same period. In that case, the tracking difference is the 1% deviation in the returns. Due to Total Expense Ratio & other expenses (discussed in the later section), TD is almost always negative, but, in some cases, it can be positive too. Any fund with a relatively higher TD (either negative or positive) should be generally avoided. Higher TD exhibits potentially less efficient fund management.
Exhibit 1: Tracking Difference comparison of two funds
Fund A has a lower TD in the above example, so choosing Fund A over Fund B makes sense. While in most cases, investors should choose a fund with a lower TD, it doesn’t necessarily mean an investor should avoid a fund with a higher TD. This is because the tracking difference should be seen along with the Tracking error. One of the drawbacks of TD is that it compares point-to-point numbers to determine fund management efficiency. To see how the fund is managed throughout the period, Tracking Error is used.
Tracking Error (TE):
Frequent movements in daily tracking difference over a period causes higher Tracking error. It is the variability (or volatility) of daily tracking difference, a statistical term measured as the standard deviation of daily tracking difference. Avoiding jargons, if an investor is comparing multiple index funds tracking the same index, he can follow a thumb rule – the lower the TE, the more efficiently a fund tracks the index. In the below example, we can see that Fund A has less variation in tracking difference than Fund B & hence, it is better as it has lower TE.
Exhibit 2: Daily tracking difference comparison of two funds
How to see Tracking Difference and Tracking Error together?
Things get interesting when we combine tracking error & tracking difference. Ideally, both should be lower & looked in tandem to evaluate the fund performance. The below image perfectly encapsulates why it is essential for both TD & TE to be lower.
Exhibit 3: TD & TE comparison of two funds
Source: Seeking Alpha
In the above example, while Fund A has higher TE, it has still delivered better returns (i.e., smaller tracking difference) than Fund B, which has a lower tracking error. This is because tracking difference comes into play & Fund A has a lower TD compared to Fund B. Therefore while evaluating the performance of different schemes tracking the same index, investors should select the fund which has consistently delivered the lowest tracking error and tracking difference.
But why does the fund deviate from the benchmark returns?
It is practically impossible for a fund manager to achieve the same returns as the index. A fund manager faces several practical challenges that deviate the scheme return from the benchmark return, such as:
- Expenses: Passive funds charge Total Expense Ratio (TER) to cover management & operating expenses associated with managing the fund. A higher or lower TER has a direct impact on the fund returns.
- Cash holdings: Passive funds also hold a certain percentage of AUM in cash & cash equivalents (usually liquid securities) to honour investor redemptions. Since this amount is not invested, it may drag or add to the fund returns in rising or falling markets.
- Securities Lending: Passive funds may also have a source of revenue over & above the returns of the index. They can lend securities held by them to other market participants for a limited period in exchange for a fee. The additional revenue generally helps reduce costs & improve tracking difference.
- Execution Timing: Several stocks get added/removed during an index rebalance. While the index uses closing day prices for return calculation, in reality, fund managers may not be able to execute transactions exactly at the closing prices. This causes a slight mismatch in the execution price, causing tracking difference. This is also applicable for daily investor’s cashflow management.
- Delay in receipt of Dividend: When a fund receives dividends from the underlying securities, there is a timing difference between when the fund receives the pay-out and when the benchmark index accounts for those payments, which might add to the tracking difference.
- Other Costs: Passive funds also incur other expenses like GST on management fees, brokerage fees for buy/sell transactions, exit load expenses, etc., which also impact fund returns.
Apart from the above, several other factors like corporate actions (stock splits, mergers & acquisitions, spinoffs etc.) also cause tracking difference.
Over the past few years, Motilal Oswal Mutual Fund has been at the forefront of passive funds by launching a bouquet of funds, including some industry-first funds. With the aim of providing a better investor experience, MOMF has developed a robust fund management framework using insights gathered over ten years of managing passive funds. Below is a comparison of how the 1-year tracking error of MOMF’s passive funds compares with the industry average.
Exhibit 4: Tracking Error Comparison of Motilal Oswal Funds vs Industry Average
Source: MOAMC, AceMF. Data as on 31st May, 2023.
In conclusion, tracking difference and tracking error play a significant role in evaluating the performance of passive funds. Just as our daily commute experience deviations from the ideal travel time, passive funds face obstacles that cause their returns to deviate from the benchmark index. Investors need to consider tracking difference and error to understand a fund’s performance comprehensively. By considering these factors, investors can better evaluate the effectiveness of different passive fund options tracking the same index and make appropriate investment choices.
This blog was also covered in Mint on 29th August 2023, click on the link below to view: https://www.livemint.com/money/personal-finance/understanding-tracking-difference-and-tracking-error-in-passive-funds-a-comprehensive-guide-by-mahavir-kaswa-11693243288416.html?utm_source=share&utm_medium=social&utm_campaign=share_via_web
Disclaimer: The above graph/table is used to explain the concept and is for illustration purpose only. It should not be used for development or implementation of any investment strategy. Past performance may or may not be sustained in future. This article has been issued based on internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The indices mentioned herein are for explaining the concept and shall not be construed as investment advice to any party. The information/data herein alone is not sufficient and should not be used for the development or implementation of any investment strategy. It should not be construed as investment advice to any party. All opinions, figures, estimates and data included in this article are as of date. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken based on this article. Mutual Fund investments are subject to market risks, read all scheme related documents carefully.