ETFs, or Exchange Traded Funds, are new products that give investors access to an underlying asset. In most cases, they follow an index, a basket of stocks, commodities, or debt securities. ETFs are exchanged on the exchange as a single stock, as the name implies. These funds are traded at a real-time price that is almost identical to the fund’s net asset value (NAV). Unlike listed close ended funds, which often trade at considerable premiums or discounts to NAV, ETFs are structured in such a way that new Units can be created and existing Units can be redeemed directly with the fund, guaranteeing that these funds trade close to their real NAV. The entire net asset value of the fund is determined by the value of the fund’s underlying holdings at the end of the day. While these numbers are nearly identical in most circumstances, there may be a tiny variation between the ETF’s NAV and the price of the benchmark index on occasion. On any given day or over any given period, the Scheme’s performance may or may not be comparable to that of the underlying index. The tracking error is a term used to describe such variances.
Continue reading if you want to learn more about tracking mistake and how it can affect your returns. We’ll go over the following topics:
The gap between the fund’s actual returns and the returns of the benchmark index in which its underlying equities are included is referred to as tracking errors in the world of ETFs. If you’re new to ETFs and want to try your luck, you’ll need to grasp what tracking errors are and how they affect your returns. The fund’s and index’s values are nearly identical because these funds replicate the performance of the equities on a specific index. You could notice some tiny variations in some circumstances. While modest tracking errors may have little impact on your results, other factors may cause the gap between these two values to increase.
Why are there chances of tracking problems when an ETF duplicates the performance of a benchmark index? The following are some of the most typical causes of these errors:
- Expenses incurred by the ETF scheme: Because ETFs are passively managed funds, they have a low cost ratio. These funds usually have a lower expense ratio. This cost is removed from the returns before they are credited to the investor, and it may result in a tiny divergence between the ETF and the benchmark returns.
- The funds may not be fully invested at all times, as a portion of the funds may be held in cash to meet redemptions or corporate actions involving securities in the index.
- Any delays in purchasing or selling shares due to market illiquidity, settlement and realization of sale profits, and registration of any securities transferred, as well as any delays in receiving cash and scrip dividends and reinvesting them.
- The underlying index is based on the prices of securities at the end of the trading day. However, the Fund may buy or sell assets at various times during the trading session at market values that may or may not correspond to the exchange’s closing prices.
- The possibility that trades will fail, resulting in the Scheme not being able to acquire shares at the appropriate price to track the index.
- Prior to distribution and accumulated expenses, a cash position and accrued income are held.
- There are no transaction or effect costs for the index because of periodic rebalancing and corporate action stated by the firms, such as amalgamations, mergers, bonus plans, forfeiture policies, and so on. The ETFs, on the other hand, must face transaction and impact costs.
- Rounding off differences: Rounding off differences causes very little tracking inaccuracy. An ETF’s portfolio maintains the same level of diversification as the benchmark index. However, there may be some rounding off of the number of shares done while simulating this. This may have an impact on the ETFs’ overall value.
Knowing the many causes of tracking problems can help you spot ETFs that attempt to match their benchmark indexes. The smaller the tracking error, the closer the ETF is to the benchmark. Such tracking mistakes are not likely to surpass 2% per year in typical circumstances. This, however, may vary due to the factors described above, as well as any other factors that may occur, particularly when markets are extremely volatile. The Investment Managers would continuously monitor the tracking error of the ETF schemes and strive to reduce tracking error to the greatest degree practicable. There can be no assurance or promise that the plan will achieve any certain degree of tracking inaccuracy in comparison to the Underlying Index’s performance.
Market risks apply to mutual fund investments; read all scheme-related papers carefully.
What constitutes an acceptable tracking error?
An index fund should theoretically have a tracking error of zero when compared to its benchmark. Tracking mistakes in enhanced index funds are often in the 1% to 2% range. Tracking errors are common among traditional active managers, ranging from 4% to 7%.
Is tracking error beneficial or harmful?
The lower the figure, the closer the portfolio’s return should be to the benchmark’s return. The amount of tracking mistake that an investor is willing to endure, on the other hand, is neither “good” nor “bad.” It’s a personal decision that is influenced by overall investment goals.
What makes ETF tracking unique?
Some may look back at last year’s results, but performance isn’t the answer—markets fluctuate regardless of how well an ETF performs.
The most straightforward response is “Keeping track of the differences.” The tracking difference indicator is used by investors to determine whether they are getting what they paid for. As a result, it’s one of the most crucial ETF numbers to think about.
The great majority of ETFs are designed to track an index, which means they strive to match the results of a specific index. The tracking difference is the difference between the performance of an ETF and an index.
Because of a variety of circumstances, the ETF is unable to fully replicate its index. However, ETF returns do not necessarily follow the index; tracking differences might be slight or big, positive or negative.
A comparable but distinct measure is tracking error. Variability, not performance, is the focus of mistake tracking. The standard deviation is how mathematicians quantify variability. The annualized standard deviation of daily return variations between the fund’s total return performance and the total return performance of its underlying index is known as tracking error.
In layman’s words, tracking error examines the volatility in the performance gap between the fund and its benchmark index.
The total cost ratio (TER) of an ETF is the single most accurate predictor of future tracking differences. If an ETF charges 1% to track an index, then, all other things being equal, ETF returns should trail index returns by exactly 1%. That is why TER is so essential, and ETF issuers are always fighting for the lowest charge.
While TER is the strongest predictor of future tracking differences, it isn’t the only aspect to consider.
When an index’s components are rebalanced, a new company is added, or a company is removed, the ETFs that track the index must alter their holdings to reflect the current condition of the index. As a result, the ETF must purchase and sell its underlying equities, incurring trading costs in the process. These expenses must be covered by the fund’s assets, which increases the tracking disparity.
ETFs that monitor indexes with a large number of stocks, illiquid securities, or that rebalance frequently by design (such as an equal-weighted index) will have higher transaction and rebalancing costs, resulting in a larger tracking gap.
Keeping every company in an index is sometimes impractical or impossible. Thousands of securities are included in some indexes (particularly bond indexes), some of which may be difficult to obtain at a reasonable price. Some ETFs choose to hold a representative sample rather than suffer the transaction and rebalancing fees involved with purchasing and selling every security within their index.
The smallest securities have miniscule weights and have no impact on performance in indexes with thousands of securities. ETF managers may choose to omit some of those minor securities to save money.
Dividend payouts from underlying equities are received by some ETFs and distributed to ETF shareholders. ETFs, on the other hand, do not distribute dividends in real time (as index providers’ paper portfolios do), but rather at regular intervals.
The ETF will have the following characteristics: “The time between when the ETF gets a payout and when it pays those payments to owners is known as “cash drag.” Those dividends can be temporarily reinvested by investment managers, but those reinvestments come at a cost. The ETF will have somewhat different returns than the fully invested index if it keeps a portion of its portfolio in cash or engages in reinvestment operations. This is known as tracking difference.
The changes in an index’s components are instantaneous when it rebalances or reconstitutes them. In order to realign itself with the index, an ETF tracking the index must go out and transact. Prices fluctuate throughout the time it takes to buy and sell the required securities, causing a tracking gap between the index and the ETF.
Some exchange-traded funds (ETFs) lend the assets in their portfolio to willing borrowers (often short-sellers). This generates additional revenue for the ETF in addition to the index’s coverage. In brief, revenue from securities lending can assist the ETF lower its costs and enhance its tracking difference.
The amount of money made by securities lending is determined by the current capital-market lending rates for those specific securities. Securities that have been heavily shorted often attract higher premiums and can provide large securities-lending revenue, whilst others may be very small.
Finally, a variety of behind-the-scenes factors influence how well an ETF tracks the performance of its underlying index. As investors, the best tool we have for measuring how all of these elements interact and, ultimately, how effectively the ETF delivers on its promise is tracking difference. Look for tracking discrepancies that are minimal — or even positive — and that are relatively constant over time.
Is it necessary to track errors?
The Importance of Error Tracking One of the most essential criteria used to evaluate a portfolio’s performance, as well as a portfolio manager’s capacity to create excessive returns and outperform the market or the benchmark, is tracking error.
Can a tracking inaccuracy be harmful?
A positive or negative tracking difference indicates how far a fund has outperformed or underperformed its benchmark index. Because a fund’s NAV total return includes fund expenditures, the tracking difference for index funds is often negative.
Is tracking inaccuracy and volatility the same thing?
Market volatility and tracking inaccuracy have a positive association, according to empirical study. When market volatility rises, tracking error rises, and when market volatility declines, tracking error diminishes.
In a mutual fund, what is the ideal tracking error?
The tracking error of a fund is the difference between the mutual fund’s performance and the benchmark’s performance. The tracking error is used to determine how well a fund performs against its benchmark. A fund that beats the benchmark by a smaller margin, for example, will have a lower tracking error than one that beats it by a larger margin.
If a mutual fund makes a 15% return while the benchmark makes a 14% return, the tracking error is 1%. The standard deviation of this difference is used to determine how well the fund tracks the benchmark over time. As a result, tracking error reveals the consistency of a fund’s performance. For example, if a fund consistently outperforms the benchmark by 2% over time, the tracking error will be nil, however if the performance difference over time is large, the tracking error will likewise be large.
A reduced tracking error indicates that the fund’s performance is relatively close to the benchmark’s performance, or that the fund has been consistently outperforming or underperforming the benchmark. A bigger tracking error, on the other hand, indicates that the fund’s performance differs significantly from that of the benchmark. However, this inherently conveys no additional information than that the fund’s performance differs from that of the benchmark.
It could indicate that the fund is outperforming or lagging the benchmark. As a result, further investigation is required. Investors that prefer a consistent rate of return from their investments may benefit greatly from understanding the fund’s tracking error. Fund managers can also use this information to determine how well their fund is performing in comparison to the benchmark.
There is no such thing as an optimal tracking error because it is highly dependent on investor preferences and risk tolerance. Investors should prefer a lower tracking error if they believe the benchmark or markets are efficient and it is difficult for portfolio managers to continuously generate value. Despite the foregoing, if investors believe that portfolio managers may offer significant value and should not be bound by a benchmark, they should choose for higher tracking error levels.
To summarize, tracking error is a good measure of performance, but it does not reveal much information about why variation occurs, necessitating a second level of inquiry to garner more information from it.
Saravanan is a finance and accounting professor, while Banerjee is a doctorate student at IIM Tiruchirappalli.
What is an ETF’s expense ratio?
An expense ratio is a fee that a mutual fund or exchange-traded fund charges investors (ETF). This charge covers the costs of administration, portfolio management, marketing, and other services. These fees are often calculated as a percentage of an investor’s annual cost.
Is the tracking problem identical as Alpha?
The average active return during a certain time period is known as alpha. Backward-looking tracking error differs from alpha in that it gauges the standard deviation of a portfolio’s active performance. Because of outperformance or underperformance, a portfolio does not have backward-looking tracking error. Consider a portfolio that consistently outperforms (or underperforms) its benchmark by 10 basis points each month. This portfolio would have a negative (positive) alpha of 10 basis points and a backward-looking tracking error of zero. Consider a portfolio that outperforms its benchmark by ten basis points half of the time and underperforms by ten basis points the rest of the time. This portfolio would have a positive backward-looking tracking error but an alpha of zero. (Alpha and tracking error are calculated as the average and standard deviation of the beta-adjusted active return, rather than the total active return, in some literature.)
The information ratio is a reward-to-risk ratio in essence. The reward is calculated as the average of the active return, or alpha. The active return’s standard deviation, tracking error, and, more specifically, backward-looking tracking error, all pose a risk. The higher the ratio of information, the better…