How to avoid tracking errors in index funds?

An index fund typically replicates the portfolio of a diversified index like the Nifty or the Sensex.

Jun 01, 2019 09:06 IST India Infoline News Service

Result Analysis
Index funds are yet to take off in India in a substantial manner but they are big business elsewhere in the world. Vanguard and Blackrock which globally specialize in indexing, manage over $11 trillion between them. In India the alpha from long only funds has been attractive enough in most cases. But what exactly are index funds?
 
Idea of index funds
An index fund typically replicates the portfolio of a diversified index like the Nifty or the Sensex. So the index fund manager does not have to worry about what stocks to buy and what to sell. The fund manager also does not have to worry about when to buy stocks and when to sell. An index fund merely replicates the index and when the index constituents change, the portfolio of the fund also changes. The one key factor that is critical in evaluating an index fund is the tracking error, which is the extent to which the portfolio returns diverge from the index. While some difference will be there between the index returns and the index fund returns, the challenge is to keep this tracking error as low as possible. But, why does tracking error arise?
 
What drives tracking error?

Tracking error could arise due to any or all of these factors.
  • Index funds charge a TER (annual expense ratio) of around 1% which distorts the return of the fund versus the index.
  • Index funds may not be able to shift their portfolio as quickly as the actual index changes and that could also lead to tracking error. Quite often, they just sample the portfolio!
  • Index funds are required to maintain some cash in their portfolio to handle redemptions on a regular basis. This unproductive cash also distorts the returns.
  • Occasionally, fund manager do deviate from the actual index in search of alpha. While this may be a risky strategy, it also creates a gap in returns.
 
How to avoid or minimize the tracking error?
In the Indian context, due to liquid market for index stocks, the need for maintaining cash is normally at the bare minimum. Hence its impact on tracking error is not that high. Tracking error in Indian index funds stem from two sources. First, is the expense ratio, which is the total expenses that is debated to an index fund. Second, is that most fund managers do not buy the entire index portfolio but instead rely on a sample of stocks that will represent the index fairly well. This is useful in reducing the transaction cost although it exposes them to correlation shifts.
 
Here are 4 approaches that can be used to minimize the tracking error
  1. Managing the total expense ratio (TER) is the most important issue when you are trying to minimize tracking error. For example, the TER for an index fund in India is in the range of 1.10-1.25% on an annualized basis. When you are talking about average annual returns of 11% on the Nifty, TER really takes away a chunk of the returns. In global markets, the index funds have a TER of less than 0.20%. That is the kind of costing that is required to minimize the tracking error.
  2. Another strategy that global funds like Vanguard deploy is to use fair prices instead of closing prices to better align securities with their true value. Normally, fair price becomes extremely relevant in case of holdings in multiple geographies. In the Indian context, there is a difference between the closing price and the last price and that can be smoothened by using fair prices.
  3. Sampling is a more economical technical, but correlations need to be tracked  on a more real time basis to be really effective in reducing the tracking error since correlations tend to be fair dynamic.
  4. Lastly, stock lending is something a lot of index funds do globally. Tracking error is normally on the downside and stock lending helps index funds to increase their fee income and reduce the tracking error gap.

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