Investigating which index fund exhibits a lower deviation from its benchmark return?
In the world of investing, choosing the right index fund can be a daunting task, given the plethora of options available. One such category that presents a unique challenge is small-cap index funds.
These funds, which offer equity exposure to smaller companies, are often sought after by investors. However, they come with a higher tracking error compared to large-cap index funds.
Tracking error, a measure used to differentiate index funds, indicates how consistently a fund tracks its underlying index. In the case of small-cap index funds, the higher tracking error signifies a greater deviation from the benchmark index.
This deviation is primarily due to three key factors: mutual fund expenses, cash balance of index funds, and problems in buying or selling underlying index stocks. Small-cap stocks, being less liquid and more volatile, tend to have wider bid-ask spreads, increasing transaction costs and making it more challenging for index funds to perfectly replicate the benchmark index. Additionally, small caps tend to have higher price volatility, causing greater short-term performance deviations.
Despite the higher tracking error, investors may still consider investing in small-cap index funds due to their higher growth potential and diversification benefits. Over the long term, these funds can boost portfolio returns. However, they also come with greater risk and volatility, so investors should manage allocation size, have a longer investment horizon, and possibly use systematic investment plans (SIPs) to mitigate risk.
Monitoring metrics like tracking error is useful to ensure the fund is tracking its benchmark reasonably well, but some tracking error is expected and acceptable in small-cap investing given the associated risks and rewards.
As of 16th Jan 2023, a comparison of the 1-year tracking error of small-cap, mid-cap, and large-cap index funds from four mutual fund houses shows that the tracking error in small-cap index funds is the highest, followed by mid-cap index funds and large-cap index funds.
Moreover, the buying or selling of underlying index stocks is the primary cause of higher tracking error in mid-cap and small-cap index funds. The fund manager's action of buying stocks might inflate the price of the stock, especially in mid-cap and small-cap index funds.
It's important to note that while small-cap index funds have a higher tracking error, this should not be the sole factor in deciding to invest in them. Risk tolerance and other financial planning variables should also be considered.
In the NIFTY Small Cap 250 index, more than 10 stocks have a daily trade value of less than Rs. 1 Crore. This lack of liquidity in small-cap stocks leads to a more pronounced tracking error in small-cap funds.
On the other hand, over the long term, few active funds have outperformed their benchmark index, making investing in the index itself a potential better choice. Therefore, for those seeking growth potential and broader market diversification, small-cap index funds, despite their higher tracking error, remain a viable option.
Investing in small-cap index funds may provide higher growth potential and diversification benefits for personal-finance, but they come with a higher tracking error compared to large-cap index funds, which can be attributed to factors like mutual fund expenses, cash balance, and liquidity issues. Therefore, it's crucial for investors to manage their allocation size, have a longer investment horizon, and consider using systematic investment plans (SIPs) to mitigate risks.
