The lower the tracking error, the better the index fund and it’s getting better over time as index funds lower their expenses.
The appeal of passive investments—putting money in funds where the manager does not make any active calls—is that they will deliver market-related returns (won’t underperform the benchmark index) and their expense ratio is lower than actively managed funds.
The differential between the market index and such a fund is the extent of their expense ratios and possibly a little more due to a small cash component to manage redemptions. To this end, the performance of index funds has been improving.
To be sure, the performance of passive funds is not measured conventionally—we do not look at the returns delivered. We look at a metric called the tracking error, which gauges how much the returns have deviated from those of the benchmark index.
Ideally, the returns of such funds should match those of the underlying index but due to expenses and cash equivalent component, it may be a little lower, say 99.9 percent. Obviously, the lower the tracking error, the better.
Statistically, the tracking error is defined as the annualised standard deviation of the difference in returns between the index fund and its corresponding index.
An index fund manager needs to calculate their tracking error on a daily basis, especially if it is an open-ended fund. The tracking error is calculated against the total returns index (TRI), which shows the returns on the index portfolio, inclusive of the dividend.
Tracking errors have improved
Now, we come to the data. We calculated the tracking error of a basket of 11 index funds tracking the Nifty50 over the past one, three and five years ended January 2022.
The average of this metric was 0.78 percent over the five-year period and 0.95 percent over the past three years. The tracking error improved significantly to 0.33 percent over the one-year period.
A tracking error of 0.95 percent, as per this calculation, does not mean that the returns from the index fund are that much lower than those of the Nifty—it is only the mathematical output of the process prescribed by the National Stock Exchange.
Over the three months ended January 2022, the output of this metric was 0.13 percent, which means there was further improvement.
Over time, the performance of index funds—at least those tracking the Nifty—is improving. At the cost of repetition, performance here does not refer to the returns delivered but the efficiency of tracking the index.
The funds that are better on efficiency on five-year, three-year and one-year horizons are UTI Nifty Index Fund, HDFC Index Fund Nifty 50 and SBI Nifty Index Fund.
As mentioned earlier, there has been further improvement in the past three months. The more efficient ones are Navi Nifty 50 Index Fund, UTI Nifty Index Fund, SBI Nifty Index Fund and HDFC Index Fund Nifty 50.
So, what leads to the improvement in efficiency? With increasing competition among passive funds, expense ratios are getting lower. Consequently, the benefit is accruing to investors.
Navi Mutual Fund queered the pitch by lowering fund management expenses, which is influencing other MFs.
Navi has been quick to acquire the top slot, even though it is a new entrant, by improving the tracking error since November 2021, helped by very low fund recurring expenses. This is expected to be in place in the future as well.
ETF tracking errors not quite the same
There are also tracking errors for the exchange-traded funds (ETFs), though there is one fine point of difference between them and index funds in the context of this metric.
ETFs are bought and sold at their market price, which can be slightly different from their net asset value (NAV). The tracking error of ETFs is computed based on their NAVs, which is the closing price of the day and not the actual price at which an investor bought or sold units.
So, the computed tracking error is just an indicative number and not the actual difference between index returns and investor returns.
Each ETF investor will have a different tracking error, whereas every index fund investor will have the same tracking error because everyone is allotted units at the respective day’s NAV.
With increasing efficiency through technology and fund-running costs, investors are better placed now. Savvy investors may compare various index funds by their tracking errors and make investment decisions.