The importance of tracking error while selecting an index fund - my article in Midday, Gujarati

How do you select an index mutual fund to invest in? Which is the critical factor? Click on the link below to read my article ...

http://epaper.gujaratimidday.com/epaper/21-mar-2016-2-edition-GMD-Page-1.html

The English translation of the article is as under:

How do you choose an index fund?

A few months ago, we had written about index funds being a good option for first time investors in equity. We believe that someone starting to consider investing in equity should seriously look at an index fund. One can later on graduate to an actively managed fund and only later to buying stocks directly. Investing in equity index fund is a simpler task and carries less risk as compared to the other alternatives.

Now first of all, let us understand the meaning of “less risk”. Equity as an asset class is considered to be risky since the prices are volatile. This would remain so irrespective of whether one invests in stocks directly or in an actively managed mutual fund or in an equity index fund. The risk of volatility does not go away. However, the volatility is at two levels – one at the stock level and the other at the market level. Investment in any diversified portfolio – whether actively managed or index – removes the risk of individual stock level volatility through the process of diversification. The market wide volatility does not go away. This is a risk that cannot be reduced or removed through diversification.

That said, an index fund is supposed to mirror a benchmark index.

This means the index fund would ideally (or at least theoretically) carry the same level of risk as the index. This means one of the measures of risk we discussed about earlier – standard deviation – would be (once again, at least theoretically) the same as that of the index and the other – Beta – would be one.

Also the returns from the index fund should be equal to that of an index less the expenses charged.

As explained, the risk and the return from the index fund should be the same as the index. However, in reality it may not be. This is exactly what we need to measure. Does the index fund behave the same as the index? Does it track the index properly? If not, what is the “tracking error”?

Tracking error attempts to measure the deviation in the risk-return profile of an index fund compared to its index.

The reasons contributing to the tracking error are as listed below:

·      Expense ratio

o   The index value is calculated considering the closing values of the stocks it comprises of, whereas an index fund’s NAV would be calculated after deduction of management and other expenses from the total value of all the holdings. This expense ratio would mean the fund should underperform the index it tracks.

·      Bid-ask spread and the transaction costs

o   The index value is calculated using the closing prices of the stocks in the portfolio. However, when the fund transacts in the market, either to buy or sell a stock, the transaction happens depending on the price at which there are buyers or sellers present. There is always a difference between the prices offered by the buyers as against the sellers. This spread results in the fund paying more while buying and getting less while selling.

o   At the time of a transaction, the fund has to pay certain charges, e.g. brokerage. This is an additional cost resulting in reduction in performance.

·      Time of transaction

o   The fund would buy or sell the stocks during the day, whereas the index value is calculated based on the closing prices. Most fund try to transact closer to the time of closing of the market to reduce this difference.

·      Cash held in the portfolio

o   In order to service redemptions as well as the delay in deploying the money received from new investors result in the fund holding some cash in the portfolio. This cash behaves differently from the portfolio of stocks. This again results in performance difference.

·      Dividends declared by companies as well as other corporate actions

o   Companies pay dividends, which are received by the fund. However, the fund may choose not to pay the dividends to its unitholders. Similarly, the fund may also offer growth option, in which the dividends are not paid. The index values are calculated without factoring the dividends.

o   Various other corporate actions would also mean the fund performance may differ from the index.

·      Changes in the constitution of the index

o   When the index constitution changes, the fund has to make changes accordingly. All the transactions result into some costs. These costs put a downward pressure on the performance.

Given the above discussion, one must look at the tracking error of an index fund – in fact, that is the only thing one needs to look at. Lower the tracking error, better is the fund – as it remains true to the label. Higher tracking error means the fund is not properly tracking the index.

While most of the factors contributing to the tracking error are very difficult to measure, the one factor that must be considered is the expense ration charged by the asset management company. This number is mentioned in the fact sheet of the fund. Here again, since all expenses are a drag on the performance, lower the expense ratio, lower would be the tracking error and hence better the fund.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster –Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.

Hum nahin sudharenge ...

Yesterday, an article I wrote appeared in Mint.  (See the link below)

Understanding the line “past performance may or may not be sustained”

The article talked about how looking at a single period could be unfair and wrong.

And another newspaper surprised us by carrying a very similar article - repeating the same mistake today.

Her is the link to that article:

Sector funds beat diversified peers in 10-year SIP returns

Remember Infrastructure funds outperformed the diversified funds in 2007-08 and Tech funds beat these funds hands down in 1999-2000.

Lekin hum nahin sudharenge.

Draw conclusions based not on one but various time periods

Conclusions should not be made based on one game. It is unfair, and it is also incorrect

Click on the link below to read my article published today in Mint:

Draw conclusions based on not one but various time periods

Pros and cons of investing through Equities - chat transcript 14th March 2016

Click on the link below to read the transcript of my chat on www.moneycontrol.com


Equity investments simplified

Where does this road lead to? - My article on www.moneycontrol.com

Where does this road lead to? Asking the right question can put you on the right path. It holds good in the world of personal finance too.

Read more at: http://www.moneycontrol.com/news/planning/where-does-this-road-lead-to_5859581.html?utm_source=ref_article

10 years back, South Africa taught us a lesson in personal finance

On 12th March 2006, Australia created a world record scoring the highest total in a One-day International match against South Africa. They scored 434/4. The record lasted for around 3 1/2 hours as South Africa won the match by scoring 438/9.

There is a lesson for all of us to learn.

Click on the link below to read my article ...

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Transcript of my chat on "Master Your Money" segment on www.moneycontrol.com on 8th March

Click on the link below to see the transcript of my chat yesterday:

http://www.moneycontrol.com/news/mgmtinterviews/chats/detail_new.php?chatid=24&source=mym

Master Your Money chat on www.moneycontrol.com

I will be doing a live chat on the Master Your Money section on www.moneycontrol.com tomorrow at 3 PM to 3:30 PM.

What do equity fund managers do to beat the index?

What strategies do equity fund managers use to outperform the benchmark indices? Read my article published in Gujarati Mid-day today ...

http://epaper.gujaratimidday.com//epaperpdf/gmd/07032016/07032016-md-gm-16.pdf


The English translation is as under:

How does an equity fund manager generate better returns than the index? This is a question many might have but few seem to ask. The first thing we need to understand, though obvious, is that the objective is to beat the index performance.

With this objective, the fund manager has to have a portfolio that is not exactly replicating the index portfolio. This means, the stocks in the fund portfolio may be different from the index. However, since the fund may be benchmarking against a particular index it tries to beat, the fund manager has to invest in stocks from a similar universe as the index.

A large-cap fund, benchmarking against Nifty must invest only in large-cap stocks. It cannot buy mid-cap (or small-cap) stocks only with an objective of beating the index.

There are two primary strategies that a fund manager may employ in order to outperform the index.

1.     Stock selection: This involves selecting stocks that are likely to perform better than the index over long term and / or avoiding stocks that are likely to underperform the index. The basis for such selection largely is the fundamental strengths of the company. As a variant of the same, the fund managers may employ sector rotation strategy. Mostly, the stocks are selected for long-term holding (though, not always).

2.     Market timing: The fund managers try to predict short-term price movements of the entire markets and accordingly increase / decrease their exposures into the market as a whole.

One such variation includes buying “value” stocks or “growth” stocks. A value stock is one whose market price is too low compared to the estimated value that the fund manager puts on it. The question is: how can such a thing be possible in a market that has access to all the relevant information? The reality is: It happens. However, the fund manager must be doubly sure as a stock trading at discount to its value means that either the fund manager knows something that the market does not or vice versa. The risk here being, “What if the market is right?” On the other hand, if the fund manager happens to be right, there could be lots of money to be made. Some of the legendary investors, e.g. Warren Buffett and Sir John Templeton are known to be value investors. A growth stock is one where the company is exhibiting a very high profit growth. Such companies are favourites of the markets. The market players love such stocks and want to own these. Such attraction means these stocks may be trading in the market at way above their intrinsic value. The risk here is (1) buying the stock too costly, or (2) slow down of the expected growth. However, some of the small and mid-sized companies become big when they continue to grow at high rates for long periods of time. There have been many examples of such stocks in our own markets. Many fund managers in India do not want to be bucketed in anyone of these two styles. They call themselves “style agnostic”. They claim that they would pick up a stock if their analysis suggests that it is a good buy, irrespective of whether it is growth stock or value stock. Academics term this style as “blend” – a mix of value or growth. A sub-style of value investing may be known as dividend yield strategy, in which the fund managers try to pick up stocks, with the main criteria being high and sustainable dividend yields. (Dividend yield is calculated as the dividend in Rupees divided by current market price).

Another variation of the “stock selection” strategy could be to identify a sector of the economy or an industry or a group of industries and own stocks of companies within these sectors. While in the value or growth style, the fund manager starts identifying the companies based on their individual businesses, in this method, they start with identification of sectors and then they search for companies within these sectors. The purists avoid such strategies. The risk here is that not all companies in a sector may be good and one may end up buying low quality stocks simply because the sector is hot.

The market timing is a very different strategy. The market timers, as we mentioned earlier, increase or decrease their exposure to the entire market based on the expected short-term price movements. If the fund manager expects the prices to move up, he would load up the portfolio with stocks. However, if the view is negative, the stock exposure may be reduced and accordingly the portfolio would carry large amount of cash or debt securities. Their idea is to stay away from equity markets if a fall is expected and come back just before a rally starts. This sounds very nice in theory, but is extremely difficulty (almost impossible) to do practically.

While the fund managers may be using both strategies, they primarily use stock selection or it’s variations. Many actually claim that they cannot time the markets and that they employ stock selection strategy, by selecting good stocks and avoiding bad stocks.

Whatever their belief and strategy, the objective is to beat the benchmark index.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.