Which Investment Fund Offers a Lower Deviation from its Benchmark?
**Small Cap Index Funds Face Higher Tracking Error, but Are Still a Wise Investment Choice**
Small cap index funds, which invest in smaller companies, tend to have a higher tracking error compared to their large cap counterparts. This is primarily due to the liquidity constraints and the complexity of replicating the small cap index, as smaller companies generally have lower trading volumes and less market liquidity.
The higher trading costs and price fluctuations associated with small cap stocks also contribute to the tracking error. Over a dozen mid cap stocks have a daily trade value of below Rs 3 crore each, and a single fund manager's action to invest in a mid cap or small cap stock can affect the price of the stock.
Despite the higher tracking error, small cap index funds offer several advantages. They provide low-cost exposure to broad market segments and generally outperform most active funds net of fees over the long term. While small cap index funds may deviate more from their benchmark in the short term, the long-term diversification and potential growth they offer can balance this drawback.
Tracking error is just one aspect to consider when investing in small cap index funds. Expense ratios, investment horizon, and diversification benefits are equally important. When selecting a small cap index fund, tracking error can be used as one of the factors to choose a good fund with a lower tracking error. A difference of 5-20 basis points in the tracking error from mid cap and large cap category should not deter investment in small cap funds.
Investors should consider their risk tolerance, investment objectives, and the role of small caps in their portfolio rather than focusing solely on tracking error metrics. Choosing the right index fund can be challenging due to the variety available, but a careful evaluation of these factors can help in making an informed decision.
A comparison of the 1-year tracking error of small cap, mid cap, and large cap index funds was carried out across four mutual fund houses. The table shows that the tracking error in small cap index funds is the highest, followed by mid cap and large cap index funds.
One example of a mid cap stock is Hatsun Agro Product, which has a daily trade value of Rs 93.93 lakh and a weight of 0.26% in the NIFTY Midcap 150 index. Despite its lower liquidity, investing in the index itself can be more beneficial than many active funds over the long term.
In conclusion, while small cap index funds face higher tracking error due to market liquidity and volatility characteristics, this is not inherently a reason to avoid them. Investors should carefully consider their investment goals, risk tolerance, and the role of small caps in their portfolio before making a decision.
The first sentence: "Investing in mutual funds, especially small cap index funds, requires careful consideration of their higher tracking error, but they still provide low-cost exposure to broad market segments and have the potential to outperform active funds over the long term."
The second sentence: "In personal-finance management, tracking error is just one factor to consider when choosing a small cap index fund. Expense ratios, investment horizon, and diversification benefits are equally important factors to make an informed decision."
