What is Index Fund: Meaning |
Source: Captial

To assess an index fund, some might turn to last year’s performance, but performance is not the answer. Markets go up and down regardless of how well an index fund does its job. The simplest answer is “tracking error”. Tracking error is the investors’ metric for assessing whether they are getting what they pay for. As such, it is one of the most important indexes fund statistics to consider.

However most index funds aim to track an index—which means that they try to deliver the same returns as a particular index. However, the difference between fund return and index return is rarely nil. The fund usually trails its index. That is because several factors prevent the fund from perfectly mimicking its index. This difference can also be small or large, positive, or negative. 

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Example – 
  • Index – NIFTY NEXT 50 TRI 
  • Mutual Fund that mimics the above index – ICICI Pru Nifty Next 50 Index Fund

Assuming you invested a lakh of rupees in both the index as well as the ICICI Fund. 

Value of 1 Lakh after 5 Years
Nifty Next 50 – TRI1,20,167
ICICI Pru Nifty Next 50 Index Fund1,13,004

In a 5-year period, your return from the ICICI fund is less by Rs. 7163. 

Value of 1 Lakh after 1 Year
Nifty Next 50 – TRI  2,04,089
ICICI Pru Nifty Next 50 Index Fund1,89,823

Over a 1-year period, your return from the ICICI fund is less than the index returns by Rs. 14266. 

So, the above explains the difference in the performance of the fund and the index. However, it is important to look at the volatility in the difference of performance between the fund and its index.

What is Tracking Error?

Tracking error measures the consistency of excess returns of index funds over the index. It is created by taking the difference between the fund return and the benchmark return and then calculating how volatile that difference is. Tracking error is about variability rather than performance. 

It is also defined as the annualised standard deviation of the difference in returns between the Index fund and its target Index. Moreover it is always calculated against the Total Returns Index (TRI) which shows the returns on the Index portfolio, inclusive of dividend.

Factors that lead to tracking error are:
  • Expense ratio – This is the major factor that leads to tracking error. The Index Total Returns has zero Expense ratio (because it is not an actual investment – it is just a reference index). The index fund, however, typically charges 0.25% – 1% as Expense Ratio which eats into the return. 
  • Inflows/outflows in the fund – When you invest in an index fund, you get units equal to the current NAV. The fund manager though may or may not be able to deploy the sum immediately in the required proportion. And if there are redemptions, the fund manager may be keeping some cash idle to support them, and that idle cash earns little, which is another factor for a tracking error.
  • Change of Index constituents – Stocks that move out are there today but tomorrow will be replaced by the new entries. Since closing prices are used for the change, Index TRI has zero impact. Fund managers on the other hand need to sell the securities that are going out and buy those coming in which leads to slippage.
  • Corporate actions – Finally cash inflow from corporate actions might not be equal to the minimum amount required to buy all stocks of the index in the correct proportion, the portfolio will differ in small ways from the real index. This will result in the portfolio moving a little further away.

Calculation of tracking error

An Index fund manager needs to calculate his tracking error daily especially if it is open -ended fund.

  • Firstly obtain the NAV values and the TR Index values for each day of the total time required.
  • Secondly calculate the percentage change in the NAV and TR Index for each day over its previous day
  • Following compute the difference between the percentage change in the NAV and the percentage change in the TR Index for each day. 
  • Lastly, take the standard deviation of the difference obtained from the day (1) today (n) in Step 3.
Frequency distributions of realized tracking error, calculated over the...  | Download Scientific Diagram

Step 5: Additionally calculate the annualised tracking error as per the formula given below

              Annualised tracking error Standard deviation obtained (Step 4) * sqrt (250)

Following is the tracking error over a period of four years for some index funds as compared to the index they are following:

Fund NameTracking Error (%)
1 Year2 Years3 Years4 Years
Aditya Birla SL Index Fund-Reg(G)
Axis Nifty 100 Index Fund-Reg(G)0.240.23=0.230.23
DSP NIFTY 50 Index Fund-Reg(G)0.170.14= 0.140.14
HDFC Index Fund-NIFTY 50 Plan(G)
ICICI Pru Nifty Index Fund(G)
Source: Google

What is a good tracking error?

It is also useful in determining just how “active” a manager’s strategy is. The lower the tracking error, the closer the manager follows the benchmark. However, the higher the tracking error, the more the manager deviates from the benchmark.

A “good” tracking error depends upon investor preference. If the investor believes markets are efficient and that it is difficult for active managers to consistently add value, then that investor would prefer to invest in an index fund with a lower tracking error. Passive managers usually seek to demonstrate low tracking error like 0.5%—1% with return differences coming from the reasons explained above.

Even so, if the investor believes that smart active managers can add significant value and should not be “tied down” to a benchmark, the investor will tolerate higher levels of tracking error. Active portfolio managers typically show a large tracking error because they seek excess return (alpha) through their active positioning versus the benchmark. With active managers, it is common to see return differences of more than 2% in a month, which leads to an annualized tracking error of 5%. 

Why is it important to monitor tracking error in index funds?

The concept helps distils all the differences between a portfolio and its benchmark into a single number. It is an indication of how close the portfolio manager is to to the benchmark, which is important to know since the benchmark value contains the consensus view of many intelligent market participants. The “neutral” point from which the portfolio manager makes decisions. Particularly the error plays an important role in client communication that it sets appropriate expectations for how large the difference between the benchmark and the portfolio return will likely be.  

  1. How closely the fund is tracking the Index: Indeed it is important to know how close the weights of the stocks in the portfolio are to the weights of the stocks in the Index. Also closer the weightage of the stocks in the portfolio to the Index, lower will be the tracking error. 
  1. How high are the costs of the fund which ultimately affects the fund return: Undoubtedly expenses like transaction costs including broker’ commission, bid and ask spread, etc. gets subtracted from the returns of the fund – Lower the expenses incurred, lower will be the tracking error and closer will be the returns of the fund to that of the target Index.

How should You select the right index fund?

Passive investing, especially INDEX FUNDs and index fund, is recommended as a low cost-low maintenance investment option for investors looking to earn market returns. The concept has gained greater visibility with many actively managed funds trailing the indices on performance. Since the costs associated with building and managing the portfolio are low as are the distribution expenses, the costs associated with an index fund are exceptionally low. Following are the steps you need to follow to make sure you have the right index fund in your portfolio.

1. Identify the Index

Firstly, identify the index to make sure that it fits into your portfolio. Undoubtedly all passive funds are not the same. An index fund builds a portfolio that tracks an index, and this will similarly define its features in terms of risk and return. Likewise the index can vary in terms of asset class (equity, debt, gold), sub-asset class (large-cap, mid-cap, small-cap, g-secs and liquid), and in terms of strategy, say, Bharat 22 or Nifty India Consumption Index or Nifty Value Index. Investors should decide their asset allocation and then identify the index that gives them the best exposure to the asset class or strategy. 

2. Assess Tracking Error

Lastly select the index fund that gives you the most efficient exposure to the index. Not all index funds do it equally well. Index funds are designed to track indices. So higher the tracking error, greater is the deviation in terms of fund returns from index returns, which is not a positive feature. Therefore have an index fund with as low a tracking error as possible.

3. Evaluate AUM

The assets under management (AUM) of a fund offers the comfort of liquidity, as well as that of experience and longevity. So sometimes a small AUM is acceptable if the fund is from a bigger fund house. An AUM of at least ₹300 crores, lower expense ratio and lower tracking error are the filters that ideally can be applied. 

4. Periodic review

Also passive investments, too, require periodic review for performance and suitability. A change in the index composition will mean altering of the fund portfolio too. And the change may not be something that the investor is comfortable with, either on account of the stocks or bonds included or the sector or stock concentration. Similarly investors need to check the index funds periodically for suitability and relevance. 

Index funds which target NIFTY 50

Following table has the list of index funds which target NIFTY 50. We will try to shortlist the list of top 5 funds. 

Fund NameExpense Ratio (%)1-Year Return (%)3-Year Return (%)1-Yr Tracking Error (%)3-Yrs Tracking Error (%)AUM (Crs)
Aditya Birla SL Active Debt Multi-Mgr FoF(D)0.6810.208.520.220.178
Aditya Birla SL Index Fund-Reg(G)0.5813.2711.200.170.13201
DSP Equal Nifty 50 Fund-Reg(G)0.7716.084.910.600.47117
DSP NIFTY 50 Index Fund-Reg(G)0.3713.060.170.1468
Franklin India Index Fund-NSE Nifty(G)0.6712.7410.890.160.12354
HDFC Index Fund-NIFTY 50 Plan(G)0.3013.1811.920.140.112,193
ICICI Pru Nifty Index Fund(G)0.4513.2711.490.150.121,099
IDBI Nifty Index Fund(G)1.0312.6910.820.140.11247
IDFC Nifty Fund-Reg(G)0.7814.2812.390.150.12241
LIC MF Index Fund-Nifty Plan(G)1.0312.7110.860.140.1228
Nippon India Index Fund – Nifty Plan(G)0.9412.3610.980.160.13300
SBI Nifty Index Fund-Reg(G)0.4912.6511.320.140.12957
Tata Index Fund-Nifty Plan(G)0.5012.8611.640.180.1485
Taurus Nifty Index Fund-Reg(G)1.0914.6412.040.240.191
UTI Nifty Index Fund-Reg(D)0.1413.5412.160.140.113,037
Order of funds

We can filter the funds basis AUM of more than 300 Crs. Following is the list arranged in the order of funds with highest AUM to lowest AUM. 

Highest AUM 
Fund NameAUM
UTI Nifty Index Fund-Reg(D)        3,037 
HDFC Index Fund-NIFTY 50 Plan(G)        2,193 
ICICI Pru Nifty Index Fund(G)        1,099 
SBI Nifty Index Fund-Reg(G)          957 
Franklin India Index Fund-NSE Nifty(G)          354 

Out of the above 5 funds, we will filter basis other parameters mentioned below:

ParameterBest FundSecond Best Fund
Lowest Tracking Error in 3-Year PeriodUTI Index FundHDFC Index Fund
Lowest Tracking Error in 1-Year PeriodUTI Index FundHDFC Index Fund
Highest Return in 3-Year PeriodUTI Index FundHDFC Index Fund
Highest Return in 1-Year PeriodUTI Index FundICICI Pru Nifty Index Fund
Clearly, UTI Index Fund Reg-D scores over other index funds that target NIFTY as benchmark in terms of all parameters. 

Lastly, many behind-the-scenes factors affect how well an index fund reflects the returns of its underlying index. Following as investors, tracking error is our best tool for assessing how all these factors interact and, ultimately, how well the index fund delivers on its promise.

Also read: Consumer Inflation Rate May Be Much Higher than the Published One

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