What is a tracking error? How to manage tracking errors?

Tracking error refers to the divergence between the net asset value of a mutual fund scheme and the benchmark. To make the most of it while managing your investment portfolio, an investor must familiarise himself with the concept and working of tracking error.

Defining tracking error

The tracking error helps in measuring the performance of a specific investment. Moreover, it lets investors compare the performance of an investment against a particular benchmark over a certain period. Thus, it is indicative of how well a fund is managed and the risks associated with it.

In other words, you can define tracking error as the difference between the returns from an investment portfolio and the index it maps. The most obvious use of tracking error is in evaluating the performance of fund portfolio managers. It is called active risk, and its use is more common for mutual funds, ETFs, or hedge funds.

Trading costs or other friction can lead to tracking errors for index funds. For active funds, you should expect a tracking error. The manager’s responsibility is to depart from the index and lessen correlation.

Tracking error is also referred to as active manager risk for actively managed portfolios or funds. Generally, investors attach negative connotations with‘ risk’ and ‘error’. But here, they are not always negative.

Tracking error Vs. Tracking difference

An investor can use both tracking error and tracking difference to analyze funds. Tracking error indicates how often and how much the portfolio diverges from the index. On the contrary, monitoring difference shows the difference in return over a specific period.

A fund can have a high tracking error but a low tracking difference. Its returns are different from the index, yet they end up around the same when the period ends. When analyzing a fund, you can use the tracking difference to find how close the performance is. Similarly, you can use the tracking error to see how the fund tracks the index persistently.

How to calculate tracking error?

It is easy to compute the tracking error with the help of two methods. In the first method, you need to deduct the cumulative returns of the benchmark from the returns of the investment portfolio. Therefore, the formula is,

Return (P) – Return (I) = Tracking Error, where,

P stands for portfolio, and I stands for index or benchmark.

In the second method, you must deduct the portfolio returns from the benchmark. Then, you use the tracking error formula to calculate the standard deviation of the outcome. The formula is as follows:

Standard Deviation of P – B = Tracking Error, where,

P stands for portfolio returns, and B stands for benchmark returns.

How to manage the tracking error?

Generally, the fund manager decides on the different techniques suited for the scheme. Here are some indicative methods:

1.Cash reserves

A fund has to hold some amount of cash. But there are no returns on these cash reserves. To handle cash flow into an index fund, you can use several techniques. These include:

  • Invest in index futures: A futures contract helps keep your funds fully invested. The funds you allocate to the futures contract will generate the same rate of return as the index. Moreover, the entry and exit of the futures is a very low-cost transaction. Cash generated from new subscriptions or dividends can be used to invest in a futures contract until it is ready for reinvestment in stocks. After the size of the cash is large enough to invest in securities, you can close the futures position and reinvest the funds.
  • Invest in fixed income securities temporarily: The purpose of cash reserves is liquidity. Moreover, you earn dividends. You can use this cash to invest in short-term money market instruments that carry fixed income or the call money market. So, the cash reserves created for meeting exigencies can be utilized for generating returns from investments in the above securities. Such a technique helps in reducing the risk of the fund hitting the tracking error as the investment is generating a return.

2. Stock lending:

As per the scheme laid down by the Securities and Exchange Board of India (SEBI), you can use the stocks held by the fund for Stock Lending. This would in generating returns for the fund, thereby helping in managing the tracking error.

Conclusion

Whether a tracking error is good or bad depends on the type of investment portfolio. Usually, a smaller number shows tightly bound portfolio returns against benchmark returns. A tracking error helps record the difference between an investment portfolio and a particular benchmark in a single-digit number. It helps in better understanding and comparison.