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.