Tracking error is important in index mutual funds because it shows how closely the fund follows its benchmark index. A low tracking error means the fund’s returns are very similar to the index returns. High tracking error means the fund’s performance differs a lot from the index, which may not be good for investors expecting index-like returns. Tracking error helps investors understand the fund’s accuracy and reliability.
What is Tracking Error?
Tracking error measures the difference between the returns of an index mutual fund and its benchmark index. It is calculated by comparing the daily or monthly returns of the fund and the index over time. Lower tracking error means the fund is closely following the index.
Why Does Tracking Error Matter to Investors?
Investors expect index mutual funds to perform almost exactly like the benchmark. Tracking error shows how well the fund matches the index. A high tracking error can mean the fund manager is making active choices, which can increase risk. Low tracking error means less risk and more predictable returns.
What Causes Tracking Error?
Tracking error can happen due to fund management costs, cash holdings, or delays in adjusting the portfolio. Sometimes funds may not hold all stocks in the index or weights may differ. Market conditions and taxes can also affect the tracking error.
How to Use Tracking Error in Choosing Funds?
Investors should compare tracking errors of different index funds before investing. Lower tracking error means the fund will behave more like the index, which is ideal for passive investors. High tracking error funds should be checked carefully for extra risks.
Does Tracking Error Affect Fund Returns?
Yes, tracking error can affect returns because it shows how closely a fund follows the index. A fund with low tracking error is more likely to deliver returns similar to the index. High tracking error may cause returns to deviate, which can be positive or negative. Understanding this helps manage investment expectations.
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