Passive fund investments: Tracking the divergence in risk versus return
Passive funds have taken a centre stage in India in the past few years, contributing around ₹7 trillion to the overall assets under management (AUM) crossing the ₹46 trillion mark. The market regulator, Sebi, has also recognized the the emergence of passive funds, i.e exchange traded funds (ETFs), and index funds as an investment product for retail investors.
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.
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
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