In the world of finance, mutual funds have become a popular choice for investors seeking to diversify their portfolios and gain exposure to a variety of asset classes. These funds, managed by professional investment teams, pool together money from multiple investors and invest it in a range of securities, such as stocks, bonds, and other assets. While mutual funds offer the potential for attractive returns, they also come with inherent risks. One of the key considerations for mutual fund investors is tracking error.
Tracking error, also known as active risk, is a metric used to evaluate the performance of investment portfolios, particularly for passively managed ones. It measures the deviation between an investment’s returns and the benchmark index it aims to beat performance-wise. Ideally, tracking error should be low or moderate, indicating that the portfolio closely aligns with its benchmark. However, a high tracking error suggests that the portfolio manager has ventured beyond the risk profile expected of the benchmark, potentially exposing investors to unwarranted risks.
Tracking error serves as a valuable tool for assessing the effectiveness of mutual funds, hedge funds, and exchange-traded funds (ETFs). By comparing an investment’s returns to its benchmark, investors can gauge the portfolio manager’s ability to either match or outperform the broader market.
Why Tracking Error Occurs
Tracking error occurs because passive funds incur expenses, have portfolio deviations, and reinvest dividends differently than their benchmarks.
Passive funds incur operational and business expenses that eat away at the fund’s returns. Passive funds may not replicate their benchmark portfolios accurately, leading to return differences. Passive funds reinvest dividends differently than their benchmarks, causing return deviations.
Read: Strategic Dividend Investing
How to Calculate Tracking Error
Tracking Error = Standard Deviation of (P – B)
Where,
P = Portfolio Returns
B = Benchmark Return
Now, let’s calculate the tracking error step by step:
| Year | Sensex Return | ABC Fund Return | Tracking Difference (P – B) |
| 1 | 13% | 10% | 3% |
| 2 | 8% | 9% | -1% |
| 3 | 15% | 13% | 2% |
| 4 | 11% | 12% | -1% |
| 5 | 9% | 11% | -2% |
Calculate Variance of Tracking Difference:
Variance = ((3)^2 + (-1)^2 + (2)^2 + (-1)^2 + (-2)^2 ) / (5 – 1) = 15 / 4 = 3.75
Calculate Tracking Error (Square Root of Variance):
Tracking Error = √3.75 = 1.94%
In this example, the tracking error for the ABC Fund relative to the BSE Sensex is approximately 1.94%.
This tracking error of 1.94% indicates how well the ABC Fund tracks the BSE Sensex over the five-year investment period. A lower tracking error suggests a closer alignment with the benchmark, while a higher tracking error indicates more deviation. Remember that tracking error cannot be zero in index funds due to factors like the expense ratio, fund cash flow, and changes in the index composition.
Read In Detail: The Power of Free Cash Flow
Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.
