Which Fund Offers Lower Divergence from the Market Average?
Small-cap index funds, despite their higher tracking error compared to large-cap index funds, can still be a viable investment option for those seeking higher growth potential. This article aims to shed light on the reasons behind the higher tracking error in small-cap funds and provide guidance on how to navigate this investment landscape.
First, it's essential to understand what tracking error is. This metric is used to measure the consistency of an index fund in tracking its underlying index. A higher tracking error indicates a higher deviation in the returns of the index fund and its target index.
The primary reason for the higher tracking error in small-cap funds is liquidity constraints, higher transaction costs, and the complexity involved in replicating a more volatile and less liquid small-cap index. Small-cap stocks tend to be less liquid and have wider bid-ask spreads, making it more difficult and costly for funds to exactly replicate the index, leading to greater deviations or tracking error.
Other contributing factors include lower market capitalization and trading volumes, more frequent changes in index constituents, and higher price volatility and impact of corporate actions in small caps.
Despite the higher tracking error, investing in small-cap index funds can still be advisable depending on your investment goals, risk tolerance, and time horizon. Small-cap funds offer the potential for higher growth over the long term compared to large caps.
To manage the higher tracking error, investors are advised to maintain a long-term investment horizon (5+ years) to ride out volatility and capitalise on growth potential. Using systematic investment plans (SIPs) or staggering purchases can also help mitigate liquidity risks and reduce tracking error impact.
In addition, considering the fund's expense ratio and tracking error together is crucial. Lower expense ratios often help reduce the net effect of tracking error on returns. Reviewing fund capacity and stress-testing disclosures is also important, as smaller funds might face greater liquidity pressures.
In conclusion, while small-cap index funds have inherently higher tracking errors due to market structure and liquidity issues, investing in them remains advisable for investors seeking higher growth and willing to accept additional volatility and tracking risk, provided the investment is aligned with their risk profile and invested with discipline.
A table provided compares the 1-year tracking error of large cap, mid cap, and small cap index funds of four mutual fund houses, offering a clearer picture of the tracking error landscape. Remember, however, that tracking error should not be the sole factor in deciding to invest in small cap funds; risk tolerance and other financial planning variables should also be considered.
References: [1] Investopedia. (2021). Tracking Error. [online] Available at: https://www.investopedia.com/terms/t/trackingerror.asp
[2] Value Research. (2021). Small Cap Funds. [online] Available at: https://www.valueresearchonline.com/funds/small-cap-funds/
[5] Morningstar. (2021). What is Tracking Error? [online] Available at: https://www.morningstar.co.uk/uk/news/1015182/what-is-tracking-error
Investing in mutual funds that focus on small-cap companies can provide higher growth potential in personal-finance, but it's important to be aware of the higher tracking error associated with such funds due to liquidity constraints and other market factors. To mitigate this risk, one should consider factors like a long-term investment horizon, systematic investment plans, fund expense ratio, and the capacity of the fund. Additionally, tracking error should not be the only consideration when deciding to invest in small-cap funds; personal finance planning variables such as risk tolerance should also be taken into account.
