A type of mutual fund or exchange-traded fund, index funds are designed to follow certain pre-set rules. They are passive strategies, wherein the objective of the fund is to replicate the performance of underlying indices such as the Sensex, Nifty 50 or Nifty Next 50.
Index funds are open-ended mutual fund schemes, which invest in the same stocks and in similar proportions as an underlying index. The objective is to generate returns that are similar to the underlying index after expenses. Also called beta trackers, index funds track broad market indices without making an attempt to outperform the market.
The best part about index funds is “jo dikhta hain wahi milta hain” (you get what you see). If you are investing in an index fund that tracks Sensex or Nifty, then your investment portfolio will always comprise the same stocks and in similar proportion . Hence, the returns will also be in line with the performance of the underlying indices, subject to expense ratio and tracking error.
Some of the advantages of index funds:
- They are simple to understand
- They follow a discipline investment approach
- They are available at a relatively lower cost
- They eliminate human biases of active management
In case of actively managed schemes, the fund manager follows certain philosophies and reacts to information and news in a certain fashion. Now, this may or may not be favourable for the fund, owing to which performance of active funds may get exposed to systemic market risk. Hence, there can be high variations in the performance of an actively managed scheme as compared to the performance of broad market indices.
Decoding tracking difference of index funds
Since index funds follow a passive strategy, their objective (before expenses) is to provide returns that closely correspond to the total returns of the underlying index. However, there are other factors like trade execution cost, impact cost, cash drag in the form of dividend receivable and other cash balances as well as rebalancing cost which creates difference between fund returns and total returns of the underlying index. This difference is referred as tracking difference. In most cases of a rising market scenario, cash drag impacts the fund negatively. The guiding principal for the tracking difference is lower the better.
Hypothetically if we consider that the NIFTY 50 Total Returns Index delivered 12% return in the last one year, while NAV of the NIFTY 50 index fund delivered 11.60% during the same period. This difference of -0.40% (12.00% minus 11.60%) is the tracking difference of the fund.
While a negative tracking difference means the index fund has underperformed its benchmark, a positive tracking difference means it has outperformed its benchmark. However, the tracking difference of an index fund/ETF is generally negative on account of expense ratio (TER) and other transaction costs.
The tracking difference, arising due to factors highlighted above, varies across index strategies. Generally, tracking difference may be higher for a few factor-based strategies that have higher index turnover/churn, with execution cost being borne by the fund. Now, as we can see from the below table that index strategies with higher portfolio turnover ratio will have a higher churning cost resulting into a higher tracking difference.
However, it has been observed that once the fund achieves a decent size, it improves the efficiency of fund management. This happens because large fund size helps in reducing the overall impact cost of the fund.
Analysis of portfolio turnover/churn
| Index | No of Additions/Deletions | Index Turnover Ratio |
| Nifty 50 Index | 1 | 0.83% |
| Nifty Next 50 Index | 11 | 21% |
| Nifty Midcap Quality Index | 11 | 32% |
| S&P BSE Low Volatility Index | 12 | 51% |
| Nifty Momentum Index | 35 | 114 % |
Source : UTI Research, NSE Indices Ltd and Asia Index Pvt Ltd ( Period last 1 year as on Aug 30, 2022)
Decoding tracking error
Tracking error is defined as the standard deviation of the difference between daily returns of the scheme NAV and of the underlying index over a period of time.
It is commonly believed that tracking error is related to the performance of the fund. However, in reality, tracking error is an indicator of the variability in the performance of the scheme as compared to underlying index on a daily basis. Tracking error, hence, indicates the consistency of a product’s tracking difference during a specific time period.
A lower tracking error implies the scheme has been consistent in replicating the portfolio’s underlying index and vice versa. Just like tracking difference here also the guiding principal is lower the better.
Managing tracking error is all about acting correctly at the correct time that too on a consistent basis!
Let’s take an example: Mr Sharma operates with a very a busy day with back-to-back meetings. He has to order and have his lunch between those meetings. If Mr Sharma has a gap of 30 minutes between two meetings — from 1:00 pm to 1:30 pm — he has to ensure his food is delivered between 1:00 pm and 1:10 pm. If his food arrives earlier, it could get cold; if it arrives later, he may have to eat really late or skip lunch altogether.
Now, Mr Sharma’s meal depends on his making the right decisions at the right time, considering external factors do not impede his actions.
Mr Sharma has to act accordingly and make the right decisions at the right time as he does not have option of cold food or late food or skipping the food or skipping the meeting in the ideal scenario.
Similarly, in the case of managing tracking error, fund managers must take correct and timely actions. They should also be consistent across events such as daily inflows/outflows management, index rebalancing and other corporate actions taking place in underlying Index securities.
Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
