Exchange traded funds (ETFs) and index funds are becoming increasingly popular. Passive funds have made a mark globally. These funds offer the benefits of transparency and diversification at a low cost. Keeping in view the emergence of passive funds as an investment product for retail investors, markets regulator SEBI issued a circular on May 23. The 14-page circular lays down norms for debt ETFs/index funds, market making framework for ETFs and other things. Further, the circular has also prescribed a limit of 2% for Tracking Error (TE) of index funds and ETFs other than debt ETFs/index funds. Along with TE, Tracking Difference (TD) will be disclosed on the website of AMC and AMFI on monthly basis for 1 year, 3 year, 5 year, 10 year and from the date of allotment of units.
Here are the key performance statistics for TE Passive Fund and these funds are ranked on the basis of this. TE measures how consistently a passive fund follows its reference index and helps measure the quality of replication. The lower the TE, the better the fund’s performance. In the circular, TE is defined as the annual standard deviation of the difference in daily returns between the underlying index or commodity and the ETF/index fund’s NAV. Since TE does not provide information about the direction of the return differential, as it only measures additional return volatility, TD also needs to be calculated and disclosed. TD is the annual difference of the daily returns between the index or goods and the NAV of the ETF/index fund and measures the actual under or outperformance of the fund as compared to the underlying reference index. Thus, TE and TD together provide a very good understanding of the performance of passive funds.
Active funds are not required to disclose their TE. However, the calculation and disclosure of TEs also makes sense for active funds. Unlike passive fund managers, who follow a benchmark (index) tracking strategy, active fund managers are expected to take advantage of investment opportunities in inefficient markets with the aim of outperforming the mandated benchmark. In order to outperform the benchmark, fund managers always place individual bets on sectors from time to time, referred to as group rotation or market, referred to as cash calls in fund management industry parlance. is done. When outperforming an active portfolio, the important consideration is whether the value added is commensurate with the risk. It is very important to understand the risks involved.
The word error should not be misunderstood here. Error tracking is a way of measuring proactive management risk. In the case of mutual funds, benchmarks are market indices that reflect the overall outlook of all the participants in the market. Theoretically, a market portfolio is an efficient portfolio that occupies an optimal risk-return trade-off. If fund managers are deviating from the benchmark, it is expected that they will do so to outperform. It is important that investors understand how much the fund manager is deviating from the benchmark i.e. how much additional risk the fund is taking against the benchmark and TE will let you know.
TE can be an important consideration when choosing an active fund. This will help investors to weed out closet index funds. A fund with a low TE may be a Closet Index fund under the guise of an active fund. The smaller the TE, the more bound the fund return is to the benchmark return, so why should investors pay the higher expense ratios charged by active funds? It would be better for investors to invest in low cost passive funds.
On the other hand, if the TE is large, it is an indication of the risks involved which may lead to improved performance or reduced performance. TD on TE would be a very good measure to understand the additional return of the fund per unit of active risk actually taken.
Too low or too high TE are both worrying signs. However, TE should be used in conjunction with several other metrics, such as the Sharpe ratio, to evaluate actively managed funds.
Dr Rachna Baid is Professor – School of Securities Education, National Institute of Securities Markets (NISM). The views expressed here are personal.