Selecting index funds: Lowest expenses does not mean lowest tracking error!

We present tracking error data for various durations and discuss how to select an index fund with it. We find that funds with lower AUM and higher expenses could also track the index well!

Published: May 2, 2020 at 11:45 am

The tracking error of Index funds is reported for various periods. We find that even relatively expensive index fund can follow the index better than less expensive ones. What does this mean to index fund selection?

From “which is the best mutual fund for long -term investing?”, at least a few investors have started asking, “which is the best index fund for the long-term?” While this may seem like a step in the right direction, the whole idea of passive investing is lost if an investor aims to select the “best index fund” based on past data and assume it will remain the best in future.

While expenses play a major role in determining how closely an index fund tracks an index, it is not the only factor. A sudden increase in AUM (yes, that is harmful too!) or a sudden decrease can result in significant tracking errors.

Also, what an acceptable tracking error is, depends on the index chosen. It would be different for Sensex/Nifty, Nifty Next 50, Midcap 150, Smallcap 250 Banking indices etc.  So a single yardstick cannot be used to judge different types of index funds.

What is the tracking error? How is it computed?

The tracking error is a measure of the average return difference between an index fund and its index. It is measured in a similar way to the standard deviation (volatility measure).

The standard deviation tells you how much a funds individual monthly return (as an example) deviates from the average monthly return. While computing tracking error, we simply replace the average monthly return in the standard deviation formula with the index return.

Why retail passive investors should avoid using tracking error!

Tracking error is for portfolio managers. It is not an intuitive measure of performance deviations. Tracking errors depend on the duration over which it is measured – this aspect is rarely appreciated by retail investors.  Tracking error calculation does not explicitly penalise index funds that beat the index over a short period of time.

Tracking error for different durations (like trailing return) is not easily available for different durations. Therefore it is easier to compute return differences over say last 6 months, quarter, 1,3,5 years etc.

Tracking errors for ETFs is measured using NAV. This is a big mistake considering how much the ETF price can fluctuate.  The NAV is irrelevant for an ETF investor! See ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!

We shall only consider index funds in this report. A tool to compute ETF tracking error is under preparation. Only selected data is discussed in this article. The full data is available for free download below.

Index Fund Tracking Error (1 year)

Scheme Name2019-May-01 To 2020-Apr-30
IDBI Nifty Index Fund(G)-Direct Plan0.160
HDFC Index Fund-Sensex(G)-Direct Plan0.163
ICICI Pru Nifty Index Fund(G)-Direct Plan0.165
LIC MF Index Fund-Nifty Plan(G)-Direct Plan0.167
UTI Nifty Index Fund(G)-Direct Plan0.169
Nippon India Index Fund – Nifty Plan(G)-Direct Plan0.176
HDFC Index Fund-NIFTY 50 Plan(G)-Direct Plan0.178
LIC MF Index Fund-Sensex Plan(G)-Direct Plan0.195
SBI Nifty Index Fund(G)-Direct Plan0.196
UTI Nifty Next 50 Index Fund(G)-Direct Plan0.220
DSP NIFTY 50 Index Fund(G)-Direct Plan0.22
Sundaram Smart NIFTY 100 Eq Weight Fund(G)-Direct Plan0.23
ICICI Pru Nifty Next 50 Index Fund(G)-Direct Plan0.23
ICICI Pru Sensex Index Fund(G)-Direct Plan0.23
IDFC Nifty Fund(G)-Direct Plan0.24
IDBI Nifty Junior Index Fund(G)-Direct Plan0.25
Nippon India Index Fund – Sensex Plan(G)-Direct Plan0.25
Aditya Birla SL Index Fund(G)-Direct Plan0.26
Franklin India Index Fund-NSE Nifty(G)-Direct Plan0.27
Tata Index Fund-Sensex Plan(G)-Direct Plan0.29
DSP NIFTY Next 50 Index Fund(G)-Direct Plan0.32
Principal Nifty 100 Equal Weight Fund(G)-Direct Plan0.32
Motilal Oswal Nifty 500 Fund(G)-Direct Plan0.34
Tata Index Fund-Nifty Plan(G)-Direct Plan0.36
DSP Equal Nifty 50 Fund(G)-Direct Plan0.41
Motilal Oswal Nifty Bank Index Fund(G)-Direct Plan0.44
Motilal Oswal Nifty Smallcap 250 Index Fund(G)-Direct Plan0.46
Motilal Oswal Nifty Midcap 150 Index Fund(G)-Direct Plan0.53
Taurus Nifty Index Fund(G)-Direct Plan0.54

You can clearly see the increase in tracking error as we go beyond Nifty/Sensex. Now we list the average total expense ratio between Mar 2019 to Mar 2020.

Fund1y avg TER
HDFC Index Fund-Sensex(G)-Direct Plan0.1000
UTI Nifty Index Fund(G)-Direct Plan0.1000
HDFC Index Fund-NIFTY 50 Plan(G)-Direct Plan0.1077
ICICI Pru Nifty Index Fund(G)-Direct Plan0.1169
ICICI Pru Sensex Index Fund(G)-Direct Plan0.1308
Nippon India Index Fund – Sensex Plan(G)-Direct Plan0.1585
IDFC Nifty Fund(G)-Direct Plan0.1800
DSP NIFTY 50 Index Fund(G)-Direct Plan0.1946
IDBI Nifty Index Fund(G)-Direct Plan0.2408
UTI Nifty Next 50 Index Fund(G)-Direct Plan0.2700
SBI Nifty Index Fund(G)-Direct Plan0.2792
DSP NIFTY Next 50 Index Fund(G)-Direct Plan0.2900
DSP Equal Nifty 50 Fund(G)-Direct Plan0.3831
ICICI Pru Nifty Next 50 Index Fund(G)-Direct Plan0.3977
IDBI Nifty Junior Index Fund(G)-Direct Plan0.4015
Aditya Birla SL Index Fund(G)-Direct Plan0.4138
LIC MF Index Fund-Nifty Plan(G)-Direct Plan0.4838
Sundaram Smart NIFTY 100 Eq Weight Fund(G)-Direct Plan0.4838
Franklin India Index Fund-NSE Nifty(G)-Direct Plan0.5362
LIC MF Index Fund-Sensex Plan(G)-Direct Plan0.6069
Principal Nifty 100 Equal Weight Fund(G)-Direct Plan0.7115
Taurus Nifty Index Fund(G)-Direct Plan0.8269

There is not much difference between the top 5 in terms of lowest tracking error. However, the fund with the lowest tracking error – IDBI Nifty Index Fund(G)-Direct Plan – has the 9th lowest average TER with an AUM of only 161 Crores (12th largest among all 33 index funds studied).

Second place (tracking error) goes to HDFC Index Fund-Sensex(G)-Direct Plan – it has the lowest average TER and third-largest AUM (956 Crores).

Fourth place – LIC MF Index Fund corresponds to 20th lowest avg TER with just 19 Crores AUM (bottom of the pile).

UTI Nifty Index Fund(G)-Direct Plan with the lowest avg TER and highest AUM  (1729 Crores) did not end up with lowest tracking error but had only 6% more than the 1st place fund (IDBI Nifty Index).

Yes, yes, that is certainly quite good, the point is, while high AUM and low TER are helpful conditions for low tracking error exceptions are easily possible.

How should investors select index funds?

  1. Do not invest in ETFs
  2. Stay away from all indices except Nifty, Sensex, Nifty Next 50 and Nifty 100. Read more:
  3. Get rid of the obsession to invest in the best index fund. Tracking error, expenses, AUM, everything is variable.
  4. Do not look for funds with lowest expenses or lowest tracking error (it can vary a lot depending on the duration used in the calculation)
  5. Select funds with reasonable AUM (100 Crores can be a lower limit) otherwise this could happen: These five index funds beat their indices! Why you should avoid them!
  6. Select funds with a reasonably low TER and reasonable return difference wrt index over the last 1,3, 5 years and just pick one.
  7. If tomorrow your Index fund becomes second best, let it be.

How to use this tracking error datasheet?

The sheet has tracking error information for the last 1,3,6 and 9 months and 1,2,3,4,5,6,7 years as on April 30th 2020. It has also has the monthly TER from Mar 2019 to Mar 2020 and the Mar 2020 AUM. It is not formatted in a pretty way and the user will have to figure out how to use it.

  1. Shortlist funds that consistently have the lowest tracking error (say top 5)
  2. Out of these choose funds with reasonably high AUM and reasonably low TER.

These funds stand out in terms of consistent low tracking error

  • HDFC Index Fund-Sensex(G)-Direct Plan
  • IDBI Nifty Index Fund(G)-Direct Plan
  • UTI Nifty Index Fund(G)-Direct Plan (Did I just hear a sigh of relief? Better check, maybe I am wrong!)

Download the index fund tracking error data (free download via Instamojo)

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About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
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