Which Investment Fund Exhibits Lower Divergence from Its Benchmark?
Investing in Mutual Funds: Understanding Tracking Error in Small Cap Index Funds
For those looking to start investing in mutual funds, there's good news – some platforms allow you to begin without paying any commission. But when it comes to index funds, it's essential to understand the concept of tracking error, especially in small cap index funds.
Tracking error is a measure of how closely an index fund follows its target index. In the case of small cap index funds, this error is typically higher due to several factors.
Challenges in Replicating the Index
Small-cap stocks tend to be more volatile and have lower trading volumes, making it difficult to buy or sell shares to exactly match the index composition. This volatility and lack of liquidity can result in higher tracking error.
Moreover, small-cap indexes often undergo more frequent changes as companies grow, shrink, or change status, requiring funds to adjust holdings more often. This increased frequency of adjustments increases the chance of deviation from the index.
There's also a difference in index construction and classification among providers. For example, Russell, S&P, and CRSP classify stocks differently, leading to tracking differences. Additionally, the higher costs associated with trading small-cap stocks inflate tracking error compared to large-cap funds with more liquid stocks and lower trading costs.
Should You Avoid Small Cap Funds?
While small-cap funds may have higher tracking error, it's not necessarily advisable to avoid them. Instead, investors should be aware of their risks and consider them as part of a balanced portfolio.
When deciding whether to invest in small-cap funds, consider your investment horizon. Small-cap funds are generally more suitable for investors with a 5+ years horizon. You might also want to use staggered investments like Systematic Investment Plans (SIPs) to mitigate timing risks.
Before investing, it's important to monitor tracking error and liquidity. Diversifying across fund types and market caps can also help spread risk.
Key Takeaways
A high tracking error indicates a high deviation in returns between the index fund and its target index. However, this doesn't mean small-cap funds should be excluded outright. Instead, they can offer potentially higher returns and broaden diversification, especially over a long-term horizon.
When selecting a small cap index fund, tracking error can be used as one of the factors to select a good fund. But remember, it's not the only factor that should influence your decision. Other factors like investment horizon, risk tolerance, and financial planning variables should also be considered.
Here's an example of a mid cap stock, Hatsun Agro Product, with a daily trade value of Rs 93.93 lakh and a 0.26% weight in NIFTY Midcap 150 index.
In conclusion, understanding tracking error in small-cap index funds is crucial for making informed investment decisions. By being aware of the factors contributing to tracking error and considering them in the context of your investment goals and risk tolerance, you can make the most of these funds as part of a balanced portfolio.
In personal finance, one might consider investing in mutual funds, including small cap index funds, given that some platforms offer commission-free beginning. However, when contemplating small cap index funds, it's vital to comprehend tracking error, a measure that signifies the difference between an index fund's performance and its target index. This error is often higher in small cap index funds due to factors like volatile stock prices, lower trading volumes, frequent index changes, disparities in index construction, and higher trading costs. Yet, despite the potential for higher tracking error, small cap funds should not be altogether avoided, especially when considering a balanced portfolio and a long-term investment horizon.
