Tracking error is a good measure of performance but does not disclose much information on why variation takes place
By P Saravanan and Sumit Banerjee
Diversification is an essential element in the investment journey. The underlying idea is to spread the amount invested in different asset classes to reduce the risk while getting maximum returns. Mutual fund is one such investment vehicle which offers a wide variety of investment opportunities across asset classes ranging from debt, equity, money market, hybrid, and the like to investors.
These fund categories are generally marked to different benchmark indices for comparison purposes. Thus, it is essential for the investors to assess how well the fund is performing compared to the benchmark. To do this assessment, tracking error of the fund comes very handy. Let us discuss the same in detail.
What is tracking error?
Tracking error of the fund is basically the difference between the performance of the mutual fund and the performance of the benchmark. Tracking error is used to analyse how well the fund is performing compared to its benchmark. For instance, a fund that beats the benchmark by lower margins will have lower tracking error than those that beat it by a higher margin.
If a mutual fund gives a return of 15%, while the benchmark gives 14% return, then the tracking error is 1%. Over a longer period, the standard deviation of this difference is used to measure how well the fund tracks the benchmark. Hence, tracking error also shows the consistency of the fund performance. For example, when a fund has constantly beaten the benchmark by 2% over the years, the tracking error will be zero whereas if the difference in the performance over the years is high, then the tracking error will also be higher.
Magnitude of tracking error
A lower tracking error denotes that the fund performance is very close to the performance of the benchmark, or the fund has been over-performing or under-performing the benchmark at a constant rate. On the contrary, a higher tracking error denotes wide variation in the performance of the fund vis-à-vis performance of the benchmark. However, this automatically does not convey any other information other than that there is a gap in the performance of the fund and the benchmark.
It may either mean that the fund is significantly beating the benchmark or underperforming. So, one should investigate further. Understanding the tracking error of the fund is extremely beneficial for investors who like to have a steady rate of returns from their investments. It is also beneficial for fund managers to gauge how well their fund is performing as against the chosen benchmark.
Is there any ideal tracking error?
There is no such concept of ideal tracking error as it depends largely upon investor preferences and risk appetite. If investors believe that the benchmark or markets are efficient and that it is difficult for portfolio managers to consistently add value, then investors should prefer a lower tracking error. Contrary to the above, if investors believe that portfolio managers could add significant value and should not be tied down to a benchmark, then investors should go for higher levels of tracking error.
To conclude, though, tracking error is a good measure of performance but does not disclose much information on why variation takes place, and a second level of investigation is required to glean more information from tracking error.
Saravanan is a professor of finance & accounting and Banerjee is a doctoral candidate at IIM Tiruchirappalli