WHAT IS AN INDEX FUND?
Equity Schemes come in many variants and thus can be segregated according to their risk levels. At the lowest end of the equity funds risk – return matrix come the index funds while at the highest end come the sectoral schemes or specialty schemes. These schemes are the riskiest amongst all types’ schemes as well. However, since equities as an asset class are risky, there is no guaranteeing returns for any type of fund.
Index Funds invest in stocks comprising indices, such as the Nifty 50, which is a broad based index comprising 50 stocks. There can be funds on other indices which have a large number of stocks such as the CNX Midcap 100 or S&P CNX 500. Here the investment is spread across a large number of stocks. In India today we find many index funds based on the Nifty 50 index, which comprises large, liquid and blue chip 50 stocks.
The objective of a typical Index Fund states – ‘This Fund will invest in stocks comprising the Nifty and in the same proportion as in the index’. The fund manager will not indulge in research and stock selection, but passively invest in the Nifty 50 scrips only, i.e. 50 stocks which form part of Nifty 50, in proportion to their market capitalization. Due to this, index funds are known as passively managed funds. Such passive approach also translates into lower costs as well as returns which closely tracks the benchmark index return (i.e. Nifty 50 for an index fund based on Nifty 50). Index funds never attempt to beat the index returns, their objective is always to mirror the index returns as closely as possible.
The difference between the returns generated by the benchmark index and the Index Fund is known as tracking error. By definition, Tracking Error is the variance between the daily returns of the underlying index and the NAV of the scheme over any given period.
Concept Clarifier – Tracking Error
Tracking Error is the Standard Deviation of the difference between daily returns of the index and the NAV of the scheme (index fund). This can be easily calculated on a standard MS office spreadsheet, by taking the daily returns of the Index, the daily returns of the NAV of the scheme, finding the difference between the two for each day and then calculating the standard deviation of difference by using the excel formula for ‘standard deviation’. In simple terms it is the difference between the returns delivered by the underlying index and those delivered by the scheme. The fund manager may buy/ sell securities anytime during the day, whereas the underlying index will be calculated on the basis of closing prices of the Nifty 50 stocks. Thus there will be a difference between the returns of the scheme and the index. There may be a difference in returns due to cash position held by the fund manager. This will lead to investor’s money not being allocated exactly as per the index but only very close to the index. If the index’s portfolio composition changes, it will require some time for the fund manager to exit the earlier stock and replace it with the new entrant in the index. These and other reasons like dividend accrued but not distributed, accrued expenses etc. all result in returns of the scheme being different from those delivered by the underlying index.
This difference is captured by Tracking Error. As is obvious, this should be as low as possible.
The fund with the least Tracking Error will be the one which investors would prefer since it is the fund tracking the index closely. Tracking Error is also function of the scheme expenses. Lower the expenses, lower the Tracking Error. Hence an index fund with low expense ratio, generally has a low Tracking Error.