"What Fund Provides Lower Divergence from Market Performance?"
Investing in index funds can be a smart choice for those seeking equity exposure in their portfolios. However, choosing the right index fund, especially small cap funds, can be challenging due to the multiple options available. One factor to consider is the tracking error, which measures the consistency of a fund in tracking its underlying index.
A higher tracking error means there is a high deviation in the returns of the index fund and its target index. In the case of small cap index funds, a higher tracking error is typically observed compared to large cap index funds. This is primarily because small cap stocks are generally less liquid and have less trading volume.
The liquidity constraint means that when the fund manager has to rebalance the portfolio to match the index—buying or selling shares—the transactions can be more difficult and can deviate from the index holdings more significantly. This results in differences in returns between the fund and the index, thus increasing tracking error.
Moreover, small cap indices tend to have more frequent changes in constituent stocks and may have more concentrated or volatile holdings, which can increase portfolio turnover and the difficulty of maintaining an exact match to the index.
However, a difference of 5-20 basis points in the tracking error from mid cap and large cap category should not be a significant concern. When selecting a small cap index fund, tracking error can be used as one of the factors to choose a good fund with a lower tracking error.
It's important to note that tracking error is just one factor to consider when investing in small cap funds. Risk tolerance and other financial planning variables should also be considered.
The table below shows the price, volume, value, weight in NIFTY Midcap 150, and other details of several mid cap stocks with low liquidity. For instance, Hatsun Agro Product, a mid cap stock, has a daily trade value of Rs 93.93 lakh and a 0.26% weight in NIFTY Midcap 150 index.
Few active funds have consistently outperformed their benchmark index over the long term. Therefore, it's crucial to understand the factors that can affect tracking error in index funds. Three key factors are mutual fund expenses, cash balance of index funds, and problems in buying/selling underlying index stocks, particularly in mid cap and small cap index funds.
Buying/selling underlying index stocks can cause higher tracking error due to the impact on the stock price, especially in stocks with low liquidity. The action of fund managers can also lead to artificial volatility and a long period of cash holding, widening the tracking error and dragging down the returns of the index fund.
In conclusion, understanding the tracking error and its causes can help investors make informed decisions when choosing index funds, particularly small cap funds. While a higher tracking error is expected in small cap funds due to their less liquid nature, it's essential to consider other factors such as risk tolerance and financial planning variables to make the best investment decisions.
[1] Investopedia. (2021). Tracking error. Retrieved 20 April 2021, from https://www.investopedia.com/terms/t/trackingerror.asp [4] Morningstar. (2021). Tracking error. Retrieved 20 April 2021, from https://www.morningstar.co.uk/uk/articles/867421/what-is-tracking-error-and-how-does-it-affect-your-investments
- To optimize personal-finance by investing in small cap funds, it's wise to consider the tracking error, as small cap stocks often exhibit a higher deviation in returns compared to their target index due to factors such as liquidity constraints and more frequent changes in constituent stocks.
- When exploring mutual funds for investing in personal-finance, understanding factors that influence tracking error, such as mutual fund expenses, cash balance of index funds, and problems in buying/selling underlying index stocks, particularly in mid cap and small cap funds, can help make informed decisions and possibly lead to higher returns.
