Mutual funds: What tracking error says about a mutual fund?

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Tracking error could be a good measure of performance but doesn’t disclose much information on why variation takes place P Saravanan and Sumit Banerjee Diversification is an important element within the investment journey.

The underlying idea is to spread the quantity invested in numerous asset classes to scale back the danger while getting maximum returns.

An open-end fund is one such investment vehicle that provides a good style of investment opportunities across asset classes starting from debt, equity, the securities industry, hybrid, and therefore they prefer to investors.

Thus, the investors must assess how well the fund is performing compared to the benchmark. To try and do this assessment, tracking the error of the fund comes very handy. Allow us to discuss the identical well.

What is a tracking error?
The tracking error of the fund is the difference between the performance of the mutual fund and the performance of the benchmark. Tracking error is used to analyze how well the fund is performing compared to its benchmark.

For instance, a fund that beats the benchmark by lower margins will have a lower tracking error than those that beat it by a higher margin.

If a mutual fund gives a return of 15%, while the benchmark gives a 14% return, then the tracking error is 1%. Over a longer period, the standard deviation of this difference is used to measure how well the fund tracks the benchmark.

For example, when a fund has constantly beaten the benchmark by 2% over the years, the tracking error will be zero whereas if the difference in the performance is over.

The magnitude of tracking error
A lower tracking error denotes that the fund performance is very close to the performance of the benchmark, or the fund has been over-performing or under-performing the benchmark at a constant rate.

It may either mean that the fund is significantly beating the benchmark or underperforming. So, one should investigate further. Understanding the tracking error of the fund is extremely beneficial for investors who like to have a steady rate of returns from their investments.

It is also beneficial for fund managers to gauge how well their fund is performing against the chosen benchmark.

Is there any ideal tracking error?
There is no such concept of ideal tracking error as it depends largely upon investor preferences and risk appetite.
If investors believe that the benchmark or markets are efficient and that it is difficult for portfolio managers to consistently add value, then investors should prefer a lower tracking error.

To conclude, though, tracking error is a good measure of performance but does not disclose much information on why variation takes place, and the second level of investigation is required to glean more information from tracking error.

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