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Tracking Error in Index Fund

Tracking error is the difference between an index fund's returns and the benchmark index it aims to track. It occurs for several reasons: 1) Rounding off of stock units when investing results in small differences between intended and actual investments. 2) Time lags between accepting funds and executing trades allow stock prices to change. 3) Indexes are not adjusted for dividends, whereas funds reinvest them. 4) Expense ratios reduce fund returns slightly compared to the index. 5) Cash holdings needed for redemptions prevent full replication of the index.

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Saprem Kulkarni
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62 views

Tracking Error in Index Fund

Tracking error is the difference between an index fund's returns and the benchmark index it aims to track. It occurs for several reasons: 1) Rounding off of stock units when investing results in small differences between intended and actual investments. 2) Time lags between accepting funds and executing trades allow stock prices to change. 3) Indexes are not adjusted for dividends, whereas funds reinvest them. 4) Expense ratios reduce fund returns slightly compared to the index. 5) Cash holdings needed for redemptions prevent full replication of the index.

Uploaded by

Saprem Kulkarni
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Tracking Error:

Tracking Error is the difference between index fund’s portfolio returns and the benchmark index
it is designed to copy. It simply means error in tracing the respective index. As index fund is a
passive fund which tries to replicate the index.

Reasons for Tracking Error:


1. Rounding Off of Stock Units:

Let’s consider that ABC index consists of following 5 stocks with respective proportion:

Stock Proportion in Stock


Name Index Price
HDFC 23% 2200
Lupin 15% 780
TCS 22% 3150
Reliance 18% 1100
MRF 22% 58000

If investor wants to invest Rs. 1 Crore in the index funds then he should invest the money as

Stock
Amount Error
Stock Proportion Stock Stock Units Actual Error
to be (Amount)
Name in Index Price Units (Rounding Investment (Units)
invested in Rs.
Off)
HDFC 23% 2200 2300000 1045.46 1046 2301200 0.55 1200
Lupin 15% 780 1500000 1923.08 1923 1499940 0.08 -60
TCS 22% 3150 2200000 698.41 698 2198700 0.41 -1300
Reliance 18% 1100 1800000 1636.36 1636 1799600 0.36 -400
MRF 22% 58000 2200000 37.93 38 2204000 0.07 4000

Total Actual Net


10000000 10003440 3440
Investment Investment Error

In the index, stock units cannot be bought or sold in fraction. So after rounding off the units, there
is difference between the expected investment and actual investment.
2. Time difference between accepting and executing order:
There is difference in time between issuing the units of the index fund to the investor and then
using this accepted money to actually buy constituents of the index. The stocks in the index
may have gone price chance leading to the negative or positive tracing error.

3. Indices are not dividend adjusted.


The stocks that form the index might announce dividends. This money comes out of the index
and paid to the investors where index funds are also investors. The money which index funds
receive from dividends, they re-invest it in the index fund. In this scenario, index fund might
beat the index but by very small margin leading to an error.

4. Expense Ratio
The expense ratio is the annual fee that index funds charge their shareholders. It expresses
the percentage of assets deducted each fiscal year for fund expenses. This is taken out from
the profit of the index fund which leads to the tracing error.

5. Cash portion

Index funds need to hold certain portion of their portfolio in cash and cash equivalents to
handle redemption request. Because of this cash portion, there is tracing error between
index and index funds’ returns.

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