When managing an investment portfolio, tracking errors plays a crucial role in assessing how well your investments align with the performance of a chosen index or benchmark. This article dives into the concept of tracking error, explaining why it matters for investors and how it can impact your returns. Whether you're looking to fine-tune your portfolio or evaluate your fund manager’s performance, understanding tracking errors will help you make more informed investment decisions.
Here's a closer look at how tracking error works and how you can use it to your advantage in portfolio management.
Tracking error can be described as the relative risk of an investment portfolio compared to its benchmark. It helps to measure the performance of a particular investment and compare its performance against a benchmark over a specific period. As a result, it serves as an indicator that helps to understand how well a fund is managed and what risks accompany it.
In simpler words, tracking error can be defined as the difference between an investment portfolio’s returns and the index it mimics or tries to beat. Tracking error often comes in handy in gauging the performance of portfolio managers and is known as active risk and is mostly used for hedge funds, ETFs or mutual funds.
These pointers indicate the importance of tracking error –
Typically, there are two distinct ways of computing tracking errors.
In the first method,
The cumulative returns of the benchmark are deducted from the investment portfolio’s returns –
Tracking Error = Return(P) – Return(i)
Here,
P = portfolio
i = index or benchmark
In the second method,
The portfolio returns are deducted from the benchmark first. Subsequently, the standard deviation of the outcome is calculated using this tracking error formula –
Tracking Error = Standard Deviation of (P – B)
Here,
P = Portfolio returns
B = Benchmark returns
Suppose a large-cap mutual fund is benchmarked to S&P 500 index; its index and mutual fund realised the following returns over 5 years –
For S&P 500 Index –
12%, 5%, 13%, 9% and 7%
For Mutual Fund –
11%, 3%, 12%, 14% and 8%
From the available data, the series of differences stood at –
(11% – 12%) = -1%
(3% – 5%) = -2%
(12% – 13%) = -1%
(14% – 9%) = 5%
(8% – 7%) = 1%
With the help of the tracking error formula–
TE = Standard Deviation of (P – B)
= 2.79%
Any fund showing a low tracking error signifies that its portfolio is following its benchmark quite closely. Conversely, a high tracking error signifies that a fund is not following the set benchmark.
Notably, in index funds, the tracking error is never zero because of – expense ratio, funds’ cash flow, and portfolio realignment due to changes in index composition.
The type of investment portfolio decides whether a tracking error is good or bad. Typically, a smaller number indicates tightly bound portfolio earnings against benchmark returns. For instance, index fund managers opt for passive management and try to keep the differential returns significantly low to keep the tracking error low. Regardless, the decision of whether a certain degree of tracking error is good or bad depends entirely on the objectives of the investment.
Several factors tend to influence the tracking error. The table below highlights the factors that affect the ETF’s tracking error:
|
Factors Affecting Tracking Error |
|
|
Factor |
Impact |
|
Discounts & Premium to NAV |
Bidding the market price of ETFs above or below their NAV results in discounts or premiums, further leading to divergence. |
|
Cash drag |
Cash holdings are a factor with ETFs, as there is a significant time lag between receiving and reinvesting cash. This leads to a variance in tracking error. |
|
Optimisation |
ETF providers cannot purchase thinly traded stock on benchmark without raising their prices upwards. This is why they use samples that comprise more liquid stocks that can serve as a proxy to index. |
|
Currency hedging |
Owing to the cost of currency hedging, foreign ETFs that implement it usually do not follow any benchmark index. Factors like interest rates and volatility affect the price of hedging and, in turn, influence the tracking error. |
|
Capital gain distribution |
Though ETFs are tax-efficient, they distribute taxable capital gains. Such distributions tend to impact performance differently than the index. |
|
Changes in index |
ETFs must keep up with the changes in the index. Generally, an ETF portfolio is likely to incur a transactional cost during the update. |
|
Security lending |
ETF companies may counterbalance tracking errors with the help of securities lending. It is essentially a practice of lending holdings in ETF-based portfolios so that one could hedge funds for short selling. |
|
Expense ratio |
A high expense ratio influences the performance of ETF funds negatively. |
|
Illiquidity and volatility |
Illiquid securities often accompany a bid-ask spread, leading to tracking errors. Similarly, the volatility of the benchmark also influences the tracking error. |
Performance Measurement: It is quite helpful in tracking to what extent a portfolio tracks a benchmark so that investors can determine the effectiveness of the fund manager.
Risk Evaluation: It provides insight into the relative risk of the portfolio in relation to the benchmark so that investors can gain understanding about the risks involved.
Consistency Check: It helps measure the consistency of excess returns, giving a clearer view of if and how much the funds are delivering on their strategy over time.
It simplifies comparison: It helps in simplifying the comparison of different funds or strategies by translating performance differences into one easily understandable number.
It is an indicator of active management: A higher tracking error usually means that it is an indicator of active management and therefore to what extent the portfolio deviates from the index in the name of achieving higher returns.
Tracking error performs a different role in an active compared to a passive investment strategy. For instance, in index funds, as in all other types of passive investments, the lesser the tracking error, the better it is to mean that a portfolio tracks close to a benchmark with minimal deviation.
In contrast, in active strategies, funds tend to have higher tracking errors because fund managers deliberately deviate from the benchmark attempting to perform better than the benchmark. This distinction provides clarity to investors on whether their selected strategy actually serves its intended purpose--whether it is tracking the index closely or adding excess returns with active management.
Tracking error is extensively used to measure and compare a fund's underperformance and outperformance against its benchmark. Typically, investors prefer a high tracking error in the event of a certain degree of outperformance. Alternatively, a low tracking error is preferred during consistent underperformance. Regardless, tracking error does not help distinguish between the two right away.