Investment in Passive Mutual Funds: 6 Points Investors Must Know About Tracking Error in Passive Mutual Funds
Investors opting for passive mutual funds look to mirror a benchmark index’s performance. However, the fund’s returns are not always the same as their benchmarks. Their difference is picked up by tracking error, a key measure that allows investors to compare how closely a fund reproduces its benchmark.
What is a Tracking Error?
Tracking error is the deviation of a mutual fund’s return from its benchmark index. It is one of the most important factors in determining how closely a fund follows its benchmark’s performance.
How is the Tracking Error Calculated?
Tracking error is the standard deviation of the difference between the returns of a fund and its benchmark over a specified period. The statistical number provides investors with an indication of the extent of fund performance deviation.
Why Does Tracking Error Occur?
Tracking error is caused by a number of factors, ranging from expense ratios, holding of cash, portfolio drift, trading cost, to tax. These factors may hinder a fund from matching its benchmark precisely.
High and Low Tracking Error
Low tracking error indicates that the fund closely tracks its benchmark, and this is most appropriate for index funds. A high tracking error, on the other hand, would indicate a significant deviation and would primarily be a result of active management decisions in a fund.
Implications for Investors
For passive investors to earn returns similar to the benchmark, they want lower tracking errors. Active management in the fund is perhaps implied through higher tracking errors, and it might lead to more risks. Investors should choose funds according to their risk tolerance and investment goals.
Implications of Understanding Tracking Error
Having a true estimate of tracking error enables investors to make good judgments when they choose mutual funds. In index funds or actively managed funds, tracking error is one of the principal measures of judging the consistency of performance.
