A Guide to Error Tracking in Mutual Funds

We`re happy! Growing awareness about Gold ETFs as a convenient means of investing in gold, has led to a surge in demand for the product. Great!

But due to a rise in demand, we have also seen many new funds mushrooming. With multiple choices and limited knowledge, which fund should you pick? How should an you address this confusion? And as one of the most significant aspects of an ETF is tracking error - how do you monitor this and invest in the right fund?

We don`t have all the answers, but we have tried to explain a little of what we know. Read on.

In Q4 of 2010, the World Gold Council reported "Indian investors increased their purchases of gold bullion as the rising price generated considerable fresh demand, without (as would usually be expected at record price levels) attracting higher levels of profit-taking." What this statement plainly proves is that the demand for gold has been on the rise. And we are also seeing a trend that Indian investors are increasingly becoming comfortable with the concept of Gold ETFs. We`re seeing investors now understanding that - Gold ETFs are as good as gold- and not dismissing the avenue as a mere paper product; all in all fast making Gold ETFs a preferred investment choice for gold.

So where do you stand in all of this? With the increase in the number of funds available for investment, you should be ready with the correct data so that you invest in the right fund. Hence, if an investor wants to invest in ETFs, "Tracking Error" should be the foremost factor to be considered.

For starters: What is Tracking Error?

Technically, Tracking Error is defined as the annualized standard deviation of the difference in returns between the Index fund and its target Index. However simply put, Tracking Error is a measure of how closely an Exchange Traded Fund (ETF) follows the index to which it is benchmarked. The lower the tracking error, the closer are the returns of the fund to that of the target Index.

The tracking error indicates how closely the fund you have purchased, is tracking the Index. Fund Inflows / Outflows, Expense Ratio and Cash Levels maintained for liquidity purpose are various factors that affect tracking error

Technical reasons and non-availability of data make it challenging for an investor to calculate Tracking Error by themselves. To solve this issue, it is important that fund houses are transparent about their funds and make the tracking error available to their investors with the purpose of aiding their decision making process.

CRISIL recently (February 2011) released a report on Tracking Error. I contacted CRISIL to better understand their methodology, and found out that the index used by them has been taken from NCDEX. NCDEX is a commodity exchange and uses parameters that differ from that of fund houses, which use calculations prescribed by SEBI.

It polls spot prices from various participants across the physical market and takes an average of the spot prices after removing the outlier quotes. This price is polled from participants across domestic markets and these could differ on accounts of exclusion / inclusion of factors like Octroi, Stamp duty and VAT depending on the location of the market. Whereas all these factors are accounted for valuation of gold for Gold ETFs.

This price calculated by NCDEX also differs from the international parity price based on local demand and supply factors. Whereas the price calculated for valuation of Gold ETFs is based on the international parity price calculated using London AM Fix prices and RBI reference rate which is not impacted by local demand and supply factors.

Since these are not equal comparisons, there is a high chance of generating incorrect results which can inflate or deflate tracking error. There is bound to be a difference between the values calculated by the fund house and CRISIL and this difference also keeps fluctuating resulting in higher tracking errors. The graph included in the report issued by CRISIL mentions the Quantum Gold Fund ETF`s 1 year tracking error for the period ending 31st January 2011 as 0.3436%. This could be alarming to our investors since the tracking error calculated by us for the same period for Quantum Gold Fund is 0.0027%.

Chart: Fluctuation in the difference between valuation of Gold for QGF and NCDEX spot prices for Gold

Source:Bloomberg, QuantumAMC

Changing even one of the parameters leads to a change in the tracking error. When one of the parameters- CIF premium (that is added to the gold price before converting it to Indian Rupees)is changed, its impact on tracking error is noticeable.

*CIF for the above calculations is based on the premium used for valuation of gold for Quantum Gold ETF

As seen in the above table, you will notice that even a small change makes a significant impact on the fund`s value. Errors like these add to the investor`s confusion and distort their decision making process. CRISIL explained that due to unavailability of standardized data on the underlying benchmark and unavailability of tracking errors of all funds made them select NCDEX prices for calculation of tracking error. Also, there weren`t any disclaimers suggesting that the data provided can be expressed differently in an actual scenario.

We recommend that, any research institution attempting to calculate tracking error for gold ETFs, should ask for the tracking errors with verifiable information from the fund houses and such factual data should be willingly provided by the fund houses. In case there is any institution that refrains from providing the data, they should not be considered for comparison purposes. I am sure that investors are wise enough to understand the possible reasons for the institution`s resistance in providing data..

I appeal to all investors in Quantum Gold Fund that we have been highly transparent in the way we manage the fund and we always try to disclose all the data relevant to the investors. In case you require further details or performance measures regarding our fund, please do write to us and we will be more than happy to provide all the relevant details.

Hence, dear investor, please ensure that you take informed decisions when it comes to investing your hard earned savings.

The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.