Market regulator Sebi has introduced a cap on the tracking error (TE) of passive funds, with effect from 1 July. TE is one key metric for investors interested in index funds and ETFs. It is an indicator of how closely an index fund/ETF replicates its underlying index — the lower the TE, the better.
No room for error
“Most ETFs and index funds specify a 2% tolerance level for TE in their scheme information documents, or SIDs. Now, this has been mandated by way of regulation and will have to be managed by the AMCs,” says Niranjan Avasthi, head – product, marketing & digital business at Edelweiss AMC.
The regulator has also brought in a cap on tracking difference (TD), another metric in the passive funds space.
More specifically, mutual fund AMCs will have to ensure that the TE of their ETFs / index funds (other than in debt) does not exceed 2% based on last one year data. This will be calculated on a rolling basis every day.
In case of debt ETFs/index funds, AMCs will have to ensure that their TD based on one-year data does not exceed 1.25%. Failure to do so will have to be brought to the notice of the MF trustees and will have to be corrected.
According to Avasthi, while the TE is the ideal metric, since debt markets are quite illiquid, this can result in deviations between the fund and the index returns even when the fund portfolio replicates the index.
Hence, the TD is a simpler way to track the efficiency of a debt fund and is also easier to understand.
Pratik Oswal, former head, passive funds at Motilal Oswal AMC, says that even newly-launched index funds/ETFs will have to publish the one-year TE on a daily basis and the TD on a monthly basis. The latter will be shown for 1, 3, 5 and 10-year tenures and since inception.
Under the existing guidelines, the tracking error can be published once a scheme completes three years.
“With this, investors will be better informed,” he adds.
According to Avasthi,under AMFI guidelines, AMCs have to disclose the tracking error (annualised, using last 3 years’ data) in the monthly factsheet.
Now, as per the latest Sebi circular issued on 23 May, the TE will be calculated on a rolling returns basis using last one year data, which is better.
Sebi has also mandated that the TE and TD be disclosed on the websites of the fund houses and industry body AMFI.