While investors place implicit trust in the fund managers when they put their money in actively managed equity funds, it is important for them to track the fund’s performance. So even though they believe the fund manager is using his expertise to generate returns on the investment, it is imperative to keep tabs on how the fund is being managed and how their investment is faring. When analysing a mutual fund, both qualitative and quantitative factors should be taken into consideration. Qualitative analysis looks at factors such as the background and experience of the manager as well as the company’s investment style and philosophy. On the other hand, a simple quantitative tool is the return, and for some evolved investors, the degree by which the fund outperforms the benchmark.
The return from a mutual fund often deviates from that of the benchmark index. The extent of this deviation is measured in terms of tracking error. Tracking error is calculated as the standard deviation of the differential return, which is defined as the difference between the returns from the fund and its benchmark. The benchmark index that a fund tracks reflects the risk that the fund manager is taking when investing, enabling an investor to get a sense of the threat involved in the investment. For instance, if a fund uses S&P CNX 500 as a broad index, it means the risk level is low compared with, say, S&P CNX Nifty, which comprises a set of 50 stocks.
| How Tracking Error Differs | ||
|---|---|---|
| Fund Name | HDFC Equity Fund | LICMF Index Fund-Nifty Plan |
| Investment management style | Active | Passive |
| Category | Equity diversified | Index fund |
| Benchmark index | CNX 500 | Nifty |
| Average monthly fund return | 0.27% | 0.01% |
| Average monthly benchmark return | 0.04% | 0.35% |
| Average monthly differential return | 0.23% | -0.34% |
| Tracking error | 0.0179 | 0.0086 |
| Analysis based on 36 months' data from January 2006 to December 2008. | ||
| Monthly average NAVs and benchmark values considered; data source: NAVIndia | ||
The return that the fund earns is compared with its benchmark to check how well it is tracking. A low tracking error means the fund follows its benchmark closely. For instance, the fund manager of a passively managed fund, such as an index fund, aims at keeping the differential return as low as possible, and therefore, the tracking error should be close to zero. The investment universe of an actively managed fund is large and this widens its risk profile. The high risk profile leads to high differential returns and a relatively higher tracking error.
Unlike the NAV, which is calculated on a daily basis, the differential returns are usually calculated on the quarterly or monthly average NAVs and the corresponding benchmark values.
Tracking error emanates from transaction costs, fees, fund expenses and cash holdings. As these add to the operational cost of the fund, it is higher for an actively managed fund. While tracking error helps to know how well the fund manager is handling the fund, one must not make investments based on this alone. For instance, tracking error in passively managed funds is low because their mandate is to track the index and not outperform it. But the fund manager of an actively managed fund tries to outperform the benchmark, and hence, the tracking error comes into play.
