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.

Do you have questions about mutual funds?

Join me for a chat session on www.moneycontrol.com tomorrow at 4:00 PM to 4:30 PM

Index funds - a good idea for a first time equity investor

My article on Index Funds in Gujarati Mid-day, Mumbai edition

http://epaper.gujaratimidday.com//epaperpdf/gmd/29122014/29122014-md-gm-12.pdf


The English translation is as under:

Top of Form

Index funds

“What do you suggest for a first time investor in equity markets?”

One has seen many a first-timers start with penny stocks – the stocks of small companies quoting below Rs. 10. Some of these investors lose money, have a bad experience and then pledge never to return to equity markets. Some others make money in the short run and learn incorrect lessons – for example, some become overconfident about their skills. Some others lose money in the beginning, but learn the right lessons – by paying too high a fee to the ultimate teacher – the stock market. All these experiences are avoidable.

Someone entering the equity markets for the first time would be well advised to take the mutual fund route, learn about investing and then, if at all, try hands at stocks. However, even within the equity mutual funds, there are too many choices and it becomes difficult for one to make a good selection.

That leads to another set of questions: “Which fund manager is better?” “What if a good fund manager turns out poor performance?” well, to make things simpler, one may consider investing in an index fund. In this way, there is no question of selection or fund manager performance. How does an index fund work?

An index fund is designed to track the movement of a market index. This makes it easier for an investor to track the portfolio performance. For example, a fund tracking the popular index Sensex would move in line with the movement of Sensex. If Sensex moves up by 10%, the fund’s NAV should also move up by around 10%. We mentioned the word “around” in the previous line, since there would always be some difference between the performance of the fund and the index. This difference is called “tracking error”. A good index fund would have low tracking error.

Though there are many factors contributing to the tracking error, one important factor is the expenses charged by the mutual fund company.

SEBI has prscribed limits beyond which a fund cpompany cannto charge the scheme. For index funds, the ceiling of expenses is lower than than the actively managed schemes. The reason for this is simple: in an index fund, there is no role of a fund manager in selection of securities to buy/sell or the timing of such decisions.

An index fund could track a popular index like Sensex or Nifty, or it could track a wider index like S&P 500. We also have index funds tracking an industry – Bank Index or a PSU Bank Index. There are funds in the Indian market that help investors invest in international markets, e.g. NASDAQ, Hang Seng, etc. In developed markets, there are index funds tracking even the bond indices.

Today, with the available variety in this segment, an investor can conveniently and cheaply get exposure to variouis different segments of the market or different markets.

While selecting an index fund, one should consider the following points:

1.     The index being tracked,

2.     Tracking error of the fund – this indicates how the scheme has been managed in the past – lower the better

3.     Expense ratio – this would contribute to the future tracking error – lower the better

There is no need to look at any other factor while selecting an index fund.

In the end, let us consider the question regarding out- or under-performance. Will an index fund generate superior returns over actively-managed funds? The answer is very clear. The index is nothing but an average and an average will always generate average performance.

There will always be some funds that will do better than the index. The problem is that it is almost impossible to identify future winners in advance.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.

Bottom of Form