Let us find out which index funds tracking the Nifty, Sensex or Nifty Next 50 have the lowest tracking error using a simple and easy to understand method. If there is enough interest, I shall publish this report from time to time. We shall restrict the discussion to index funds for now.
ETF tracking error also is essential, but it will have to be done with respect to its price and not NAV (as is usually reported). Actual investor returns are based on ETF price and not NAV, and therefore, all calculations should be done with the price. Here is an example: ICICI Nifty Next 50 Index Fund vs Reliance ETF Junior BeEs. A more dramatic illustration of the price effect is seen here: ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!
I realised historical ETF price data is available at Moneycontrol only just before completing this article. Therefore I have not included ETFs here but shall do so in another post shortly. Also, I have only included Nifty, Sensex and Nifty Next 50 index funds for this study. The rest have too short a history to warrant consideration.
The job of an index fund manager is to track a given index. This may seem easy at first, as there is no active stock selection involved. However, the fund will be subjected to in and outflows and therefore, must have a small amount of cash. Corporate actions like splits and dividends will have to be accounted for. Considering all this, making sure the portfolio weights of individual stocks match closely to that of the index is not as easy as it seems. Then there are expenses to worry about. You can consult this excellent introduction to tracking error by the NSE.
Thus the NAV movement of an index fund will always trail behind the price of the underlying index. A good fund manager will minimise this lag. A measure of this lag is known as tracking error.
Tracking error is defined as the standard deviation of the daily difference between the fund return and index return: lower this value, the better. Very few people bother to understand that the tracking error depends on the duration of the calculation. A one-year tracking error can be quite different from a three-year tracking error.
Therefore, a more straightforward and more comfortable to understand check of index fund performance is necessary. I prefer to compare 1,2,3,4 and 5 years (or longer) returns of the index funds with the returns of the total returns index. A fund with a consistently low return difference has small tracking error.
Nifty Index Funds with lowest tracking error
Let us start with the trailing returns of Nifty index funds.
Now we calculate the difference between scheme return minus index return. This must be negative. If this is positive for any duration, immediately reject the fund! See, for example, these five index funds beat their indices! Why you should avoid them!
The funds highlighted in green above have a return difference lower than the median return difference. This means that they are in the top half of the pile. Investors can choose a fund with sizeable AUM among these and low expense ratio.
Since the expense ratio keeps fluctuating, one cannot infer past tracking performance based on the current expenses. Also shown above is only the trailing return data. Rolling returns can provide a better picture. I shall include this next time.
To reiterate, we have defined tracking error as consistently low return difference between the fund and index over the last 1,2,3,4 and 5 years. This is easier for investors to calculate on their own, is more comprehensive (as opposed to computing last 3Y daily returns based tracking error) and most importantly, natural to understand.
Nifty Next 50 Index funds with lowest tracking error
Sensex Index Funds with lowest tracking error
Here the HDFC fund had an active management past. HDFC Sensex plus fund was merged with HDFC Sensex fund. So its history cannot be considered. The Tata fund has impressed in this window but has too low an AUM (~ 11 Crores)
Return comparison of the index fund with index (total returns) is a simple and easy way to measure tracking performance. This can be immediately done at most fund portals. Notice that the return difference will be more than the expense ratio of the fund. This is because expenses are only one factor that contributes to tracking error.
An efficient fund manager of a slightly expensive index fund can still “outperform” a less expensive index fund! Bottom line, index funds require “active” management too! If there is enough interest in such a study, I shall repeat it for ETFs also.
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