Tracking error refers to the difference in returns between a portfolio (index fund) and a benchmark (target index) against which its performance is evaluated. In other words, it is the difference between the returns on an index fund and the returns on a target index.
An index fund is a mutual fund that invests in securities that form part of a target “basket of investments” called the target index. The index fund manager aims at investing in the target securities in proportions and weights that are similar to those in the target index. The objective is to earn a return that is commensurate to that of the target index. In other words, the index fund tries to mimic the performance of a target index. The investor attempts to replicate the financial performance of the target index by holding all the securities in the index.
Tracking Error = Portfolio return – Target index return
Suppose a given portfolio offers a 7% return while the benchmark offers a 10% return. The tracking error is – 3% (7% – 10%).
Interpreting the Tracking Error
A fund manager is said to perform well if they are able to replicate the return earned on the target index. The larger the difference between the index fund return and the target index return, the higher the tracking error. A large tracking error may be indicative of poor performance.
Importance of the Tracking Error
1. It helps to monitor the expenditure incurred by a fund: In theory, all the corpus of a fund should be invested in the securities that form part of the target index so as to achieve 100% replication. However, this is usually not possible since money keeps on being constantly drawn from the fund to meet day-to-day expenses. This means that fund managers invest less funds than what they collected. This, in turn, has an effect on returns. The manager must keep expenditures in check if they are to replicate the target index performance.
2. It may indicate management’s efficiency as far as cash is concerned: The need to meet dividend payments and requests for redemption means that a fund’s management must always set aside some cash. Alternatively, the management might have to invest in short term “vehicles” to ensure money is easily available when required. If the management holds too much cash, then it means less funds will be invested thereby increasing the tracking error. If too little cash is held, the tracking error will be smaller. However, the company might not be able to meet its liabilities, a situation which may lead to a takeover. Therefore, for efficiency, the management/fund manager must establish the right balance.
Reading 10 LOS 10h:
Calculate and interpret tracking error