Passive Investors Must Get Active About Tracking Error To Better Returns
Many market mavens state that passive investing, or index investing, is the best form of investing, especially for beginners and amateurs.
In his 1993 annual letter to shareholders of Berkshire Hathway, Warren Buffett wrote that by periodically investing in an index fund, the “know-nothing” investor can actually outperform most investment professionals.
Then does it mean that passive investors must not be aware of some of the nuances associated with the investing process?. When dipping your toes into the vast ocean of passive investing, you may encounter the term 'tracking error'.
It indicates how closely your investment voyage follows the map laid out by an index or benchmark.
What Exactly Is a Tracking Error?
All mutual funds are required, according to Securities and Exchange Board of India regulations, to link their performance to a benchmark index.
Tracking error is the indicator that tells you how much your investment portfolio deviates from the benchmark it aims to mimic.
Think of it as a measure of precision in index replication. The smaller the discrepancy, the more accurate the mirroring of the index.
The Nitty-Gritty of Tracking Error Calculation
There are a couple of ways to compute this performance gap. First, the simple subtraction method is like checking the difference in miles covered between your car and a friend's on a road trip.
If the benchmark index zoomed ahead by 10%, and your portfolio cruised at 9%, the tracking error is 1%.
The second method is more sophisticated, involving the standard deviation of these differences over time, giving a sense of the portfolio's consistency.
Is There Such a Thing as a Good Tracking Error?
The answer swings on the pendulum of investment objectives.
For passive strategies, which include instruments like ETFs and index funds, a low tracking error is the north star, guiding towards the goal of closely tracking the benchmark.
Factors That Cause Tracking Error
Many elements waltz together to influence tracking error, including expense ratios, and the inflow of funds or subscriptions and redemptions.
Fund managers monitor these factors to keep the fund’s performance in sync with the benchmark.
Significance and Limitations of Tracking Error
A tracking error doesn't just score a fund manager's performance; it also reflects the volatility and risk level of the portfolio.
Tracking error as a metric shows the difference between the performance of an investment portfolio and its benchmark. However, it does not specify whether this difference is because the portfolio performed better than or worse than the benchmark. It's a number that requires context.
Tracking Error Measures Frequency and Magnitude of Variance
Tracking error reflects how often and by how much a fund's performance deviates from its benchmark index.
It's a measure of consistency; a high tracking error indicates frequent and significant variations from the index over time.
Tracking Difference Measures Cumulative Performance Discrepancy
In contrast, tracking difference looks at the overall difference in returns between the fund and the index over a specific period.
It focuses on the end result, not the individual variations along the way.
High Tracking Error and Low Tracking Difference
It's possible for a fund to exhibit a high tracking error and a low tracking difference simultaneously.
This situation occurs when a fund's returns often deviate from the index throughout the period but eventually align closely with the index's total returns by the end of that period.
How To Use Tracking Error And Tracking Difference
Investors can use tracking error to find how consistently the fund tracks its benchmark index and tracking difference to find how close the performance is.
It can't make decisions for you, but it can sure give you insights into the fund manager's steps – are they in sync with the market's tunes or offbeat?
Sign up and follow us to get the best stories on Investments, Strategies, Tools, Ideas & Insights to help you achieve your Financial Goals.