Passive fund investments: Tracking the divergence in risk versus return

A circular on ‘development of passive funds’, released by Sebi in May 2022, defined and issued norms for tracking error (TE) and tracking difference (TD)—the two basic performance statistics for evaluating passive funds. Currently, there are over 350 passive products around 100 indices, including a few global indices. Nifty 50 TR is the most dominant choice of index for creation of index based products with 35 funds tracking Nifty50 TR.

A sample of 24 passive funds mounted on Nifty 50 TR, ranked on the basis of TR and TD, revealed the following: Though well within the regulatory requirements, some funds have much higher tracking error and tracking differences. The rankings of funds vary across TD and TE with a rank correlation of only 0.57 between the two metrics. Few funds have low TE and TD than others. Many funds have lower TE and higher TD and a few have the opposite.

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In passive investment products such as ETFs and index funds, the investment decisions are tied to changes in the underlying benchmark index as the passive funds essentially replicate the underlying index. TE and TD are the two key performance statistics for evaluating the passive funds. The circular by Sebi defines TD as the annualized difference of daily returns between the index and the net asset value (NAV) of the ETF/ index fund and the TE as the annualized standard deviation of the difference in daily returns between the underlying index and the NAV of the ETF/ index fund. Though both these two metrics indicate a fund’s divergence from its benchmark, they capture different elements of tracking performance and hence may lead to varying rankings across the two measures. TE is a measure of the relative risk of the fund. TD, though, represents a measure of the relative return.

TE gives a clue to the volatility of returns by measuring the consistency of a fund’s TD over time. The closer the TE to zero, the closer the risk profile of the fund matches the risk profile of the benchmark. TE is meant to provide a degree of confidence in predicting tracking difference. To put this in terms of probabilities, if a fund has a tracking error of 1%, one could say with 95% confidence that the relative returns of the fund to its benchmark would fall within a range of –2% to +2%. TE does not imply anything about the performance gap over a given period. TD reflects the ‘performance gap’ between the fund and benchmark. Given that TE measures relative risk and TD relative return, differences in tracking performance may arise across the two measures with implications for the investment decisions made by investors.

In general, the closer to zero for both indicators, the better a passive product has replicated its underlying index. A good tracker should minimise both TD and TE. Though both the criteria should be in the checklist of the investors, however when funds have different ranking on these two parameters, investors need to decide for the ranking based on TE or TD.

Before deciding on a particular measure, the investors should consider their investment time horizon. If the investment horizon is long-term, then TD is likely to be more important than TE for comparing funds. It is important to look at TD. There are many funds with low TE of 0.05% but have observably high TD—as high as 50 to 70 basis points that might eat into potential returns in the long run. In case of short-term investments, TE could become more relevant. However, when not sure on the investment horizon, investors will be better off making decision on the basis of TD.

Rachana Baid is professor and dean (academics), School for Securities Education (SSE), National Institute of Securities Markets (an educational initiative of Sebi).