Should tracking error be used for active funds?
Premium- Low tracking error can identify closet index funds and a high error can signal risk
Exchange traded funds (ETFs) and index funds are increasingly becoming popular. Globally, passive funds have already made a mark. These funds offer the advantages of transparency, and diversification at a lower cost. Considering the emergence of passive funds as an investment product for retail investors, market regulator Sebi issued a circular on 23 May. The 14-page circular prescribes norms for debt ETFs / index funds, market making framework for ETFs, among other things. In addition, the circular has also prescribed a ceiling for the tracking error (TE) of index funds and ETFs other than debt ETFs/ index funds at 2%. Along with TE, tracking difference (TD) shall also be disclosed on the website of the AMC and AMFI on a monthly basis for tenures of 1 year, 3 years, 5 years, 10 years and since the date of allotment of units.
TE is the key performance statistics for passive funds and these funds are ranked on the basis of it. TE measures how consistently a passive fund follows its reference index and helps measure the quality of the replication. Lower the TE, better the fund performance. In the circular, TE is defined as the annualized standard deviation of the difference in daily returns between the underlying index or goods and the NAV of the ETF/ index fund. Since TE does not provide information on the direction of return differences, as it only measures excess return volatility, TD is also required to be calculated and disclosed. TD is the annualized difference of daily returns between the index or goods and the NAV of the ETF/Index Fund and it measures the actual under or outperformance of the fund 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, calculation and disclosure of TE makes sense even for active funds. Unlike passive fund managers that follow a benchmark (index) tracking strategy, active fund managers are expected to exploit investment opportunities found in inefficient markets with the objective of outperforming the mandated benchmarks. With a view to outperform the benchmark, fund managers invariably make time - varying bets on sectors, referred to as group rotation or the market as a whole referred to as cash calls in the language of the fund management industry. When outperformance is observed for the active portfolio, the important consideration is whether the value added is in line with the risks undertaken. It is very important to understand the risks involved.
The word error here should not be misunderstood. Tracking error is simply a way to quantify the active management risk. The benchmarks in case of mutual funds are market indices which indicate the aggregated view of all the participants in the market. Theoretically, a market portfolio is an efficient portfolio, residing on an optimal risk-return trade-off. If the fund managers are deviating from the benchmark, the expectation is that they do so to outperform it. It is important that investors understand how much the fund manager is deviating from the benchmark i.e. how much extra risk the fund is taking vis-à-vis the benchmark and the TE will tell you this.
TE can be an important consideration when choosing an active fund. It will help investors in calling out closet index funds. A fund with a lower TE could be a closet index fund in the garb of an active fund. The smaller the TE, the more tightly-bound the fund return will be to the benchmark return, so why should investors pay a higher expense ratio charged by active funds? Investors would be better off investing in low-cost passive funds.
On the other hand, if the TE is large, it is an indication of risks involved which may lead to outperformance or underperformance. TD upon TE would indeed be a very good measure to understand the excess return of the fund per unit of active risk taken.
A very low or very high TE are both worrying signs. However, the TE should be used in conjunction with a host of other metrics such as Sharpe Ratio to evaluate an actively managed fund.
Dr Rachana Baid is professor - School of Securities Education, National Institute of Securities Markets (NISM). The views expressed here are personal.