18 May 2024

Will all Nifty 500 index funds have poor tracking differences?

I regularly review fact sheets of the mutual funds I invest in. I take note of some metrics to keep track of the funds’ health and performance. Starting this month, I have started noting down tracking differences of index funds.

3 years tracking difference of some popular index funds:

  • HDFC Nifty 50: 0.31 pp (percentage points)
  • UTI Nifty 50: 0.42 pp
  • Motilal Oswal Nifty 500: 1.36 pp

I was a little disappointed to see these numbers since Motilal Oswal Nifty 500 is the fund I have chosen for my portfolio. Looking at these numbers, predictions of the Motilal Oswal fund not being able to closely track its index seemed to have come true.

The linked article says that tracking 500 stocks will be more difficult than tracking 50 stocks due to impact cost and other overhead. It goes on to recommend that investors stick to Nifty 50 index funds.

If tracking 500 companies has such an impact, I wondered, what the story will be for funds that track thousands of companies? So I looked at 2 Vanguard ETFs tracking global indices. Despite holding thousands of stocks, these funds had incredibly low tracking differences.

Fund nameStocks held3 years tracking diff.
HDFC Nifty 50500.31 pp
UTI Nifty 50500.42 pp
Motilal Oswal Nifty 5005001.36 pp
Vanguard All-World (VWRA)3700+0.10 pp
Vanguard Total World Stock (VT)9800+0.52 pp

This busts the theory that tracking more companies will always lead to a higher tracking difference. A competent fund manager like Vanguard can replicate large indices without deviating too far away from the index.

This made me think of the Jio-BlackRock joint venture that is expected to launch mutual funds in the near future. BlackRock’s iShares MSCI World ETF had managed a 3-years tracking difference of -0.47 pp despite holding a large portfolio of stocks. A Nifty 500 fund run by BlackRock would likely have a low tracking difference, I thought. Then I discovered iShares MSCI India ETF, so I looked at this ETF’s tracking difference.

Recent cumulative returns of iShares MSCI India ETF
The tracking difference of the MSCI India ETF is more than 10 percentage points! This looks even worse when you consider that this ETF only holds 136 companies, possibly very liquid large- and mid-cap companies.

Takeaways for me:

  • While Motilal Oswal Nifty 500 has a mildly high tracking difference, it’s not that bad. There are worse options out there.
  • BlackRock coming to India need not be as amazing as some hype it up to be. We have to wait and see how they are able to perform.
  • Finally, some Nifty 50 index funds also have high tracking differences. NiftyBeES, India’s most popular Nifty 50 ETF, has a tracking difference of 0.98%. ABSL Nifty 50 and DSP Nifty 50 funds have tracking differences of 1.32 pp and 1.22 pp respectively. Compared to that, Motilal Oswal Nifty 500’s 1.36 pp is very respectable.

Index fund tracking error vs tracking difference

Tracking error and tracking difference are 2 metrics for assessing mutual funds that mirror an index. Let’s look at the difference between the 2 with an exaggerated hypothetical example.

Imagine there are 2 funds, Fund A and Fund B, both mirroring the same index. Let's pretend the index and the funds start at the value of 100 at time T0 and go through the following changes over time.

Absolute value of an index and 2 funds tracking it
TimestampIndexFund AFund B
T0100.00100.00100.00
T1101.54101.14101.52
T2101.11100.32101.04
T3101.1099.90101.01
T4101.88100.27101.70
T5102.31100.29102.16

Which fund do you think has a higher tracking error? Many investors would be surprised to hear that Fund A’s tracking error is 0.71% but Fund B’s tracking error is 2.95%.

Tracking difference vs tracking error?

Tracking difference is easy to understand and calculate. Take any time period. Find the difference between index return and fund return. That number is the tracking difference for that period. Tracking error, on the other hand, is a metric that tells us how consistent a fund’s tracking differences have been.

Let’s go back to our hypothetical example. The following table shows tracking difference for each time period.

Tracking differences of 2 hypothetical index funds
Time periodFund AFund B
T0T10.40 pp0.02 pp
T1T20.39 pp0.05 pp
T2T30.41 pp0.02 pp
T3T40.40 pp0.09 pp
T4T50.40 pp0.03 pp

As you can see, Fund A’s tracking differences have fallen in a narrow range of 0.39 percentage points to 0.41 percentage points. But Fund B’s tracking differences are spread across a wider range of 0.02 percentage points to 0.09 percentage points.

Tracking error is the standard deviation of all tracking differences of the fund. If the tracking differences are similar throughout the assessment period, that fund has a low tracking error. This is independent of the quantum of the tracking difference.

Index fund metrics for the time period T0T5
Fund AFund B
Tracking difference2.02 pp0.71 pp
Tracking error0.15 pp2.95 pp

What is important? Tracking error or tracking difference?

In a way, both are important. But tracking difference is a lot more important than tracking error.

  • A lower tracking difference over a long duration (such as 10 years) means that the return an investor earns is similar to the return the index earns. That is always a good thing.
  • A lower tracking error means that the process used by the fund management team can reliably replicate the index in all circumstances. Securities markets have good days and bad days. If a fund is able to replicate the index with a similar kind of tracking difference on all days, it means the fund follows a robust investment process.

How to choose an index fund?

  1. Choose the index that you want to invest in. My older posts Nifty 50 vs Nifty 500 or Not all index investing is passive may be of some help.
  2. If you have multiple funds mirroring your chosen index, then pick the one that has consistently low tracking difference over different time periods.
  3. If you still have multiple options to choose from, you can choose the fund with a lower tracking error.

But this is not foolproof. You should also appreciate and accept that we can only do Step 1 above reliably. The other 2 metrics—tracking difference and tracking error—are moving targets. A fund that has done well for many years may suddenly start to falter, or vice versa.

Do your best to choose a fund. But don’t panic or blame yourself if you make a judgement error. Just see how to course correct since that’s the only thing we can do after investing in a suboptimal fund.

Thanks to FreeFinCal for making me aware of the significance of tracking difference.

18 Apr 2024

The impact of “taxed at slab”

It’s often scary to hear the phrase “taxed at slab” because it means a relatively larger chunk of our profit is taken away by the government.

Many mutual fund categories are now taxed at slab. This has caused enough concern among investors to spur AMCs into creating weird mutual fund schemes. I know of at least Edelweiss Multi Asset and Parag Parikh Dynamic Asset Allocation funds. I am sure more such funds are coming from various AMCs.

But what is the impact of “at slab” taxation on long-term investments? We look at a few tax scenarios of a ₹50,000 per month SIP.

Estimated corpus @ 10% annualised return over 10 years

It should be no surprise, but a 30% tax bill is twice as large as a 15% tax bill and thrice as large as a 10% tax bill.

Screenshot from Groww SIP Calculator (click image to enlarge)
  • Pre-tax corpus: ₹1,03,27,601
  • Post-tax corpus with 30% tax and 4% cess: ₹89,77,389
    • Tax owed is ₹13,50,212.
    • 13.07% of the final corpus is owed as tax.
  • Post-tax corpus with 20% tax and 4% cess: ₹94,27,460
    • Tax owed is ₹9,00,141.
    • 8.72% of the final corpus is owed as tax.
  • Post-tax corpus with 15% tax and 4% cess: ₹96,52,495
    • Tax owed is ₹6,75,106.
    • 6.54% of the final corpus is owed as tax.
    • (Why 15% tax? Assuming indexation brings down the acquisition cost, the effective tax rate may be 15%. Just an unscientific estimate.)
  • Post-tax corpus with 10% tax and 4% cess: ₹98,77,530
    • Tax owed is ₹4,50,071.
    • 4.36% of the final corpus is owed as tax.

Estimated corpus @ 12% annualised return over 10 years

For the same investment duration, higher return rate results in higher tax owed (as a percentage of the corpus size).

Screenshot from Groww SIP Calculator (click image to enlarge)
  • Pre-tax corpus: ₹1,16,16,954
  • Post-tax corpus with 30% tax and 4% cess: ₹98,64,464
    • Tax owed is ₹17,52,490.
    • 15.09% of the final corpus is owed as tax.
  • Post-tax corpus with 20% tax and 4% cess: ₹1,04,48,628
    • Tax owed is ₹11,68,326.
    • 10.06% of the final corpus is owed as tax.
  • Post-tax corpus with 15% tax and 4% cess: ₹1,07,40,709.
    • Tax owed is ₹8,76,245.
    • 7.54% of the final corpus is owed as tax.
    • (Why 15% tax? Assuming indexation brings down the acquisition cost, the effective tax rate may be 15%. Just an unscientific estimate.)
  • Post-tax corpus with 10% tax and 4% cess: ₹1,10,32,791
    • Tax owed is ₹5,84,163.
    • 5.03% of the final corpus is owed as tax.

Estimated corpus @ 12% annualised return over 5 years

For the same 12% return, shorter investment duration results in lower tax owed (when looked at as a percentage of the corpus size).

Screenshot from Groww SIP Calculator (click image to enlarge)
  • Pre-tax corpus: ₹41,24,318
  • Post-tax corpus with 30% tax and 4% cess: ₹37,73,530.
    • Tax owed is ₹3,50,787.
    • 8.51% of the final corpus is owed as tax.
  • Post-tax corpus with 20% tax and 4% cess: ₹38,90,460.
    • Tax owed is ₹2,33,858.
    • 5.67% of the final corpus is owed as tax.
  • Post-tax corpus with 15% tax and 4% cess: ₹39,48,924.
    • Tax owed is ₹1,75,394.
    • 4.25% of the final corpus is owed as tax.
    • (Why 15% tax? Assuming indexation brings down the acquisition cost, the effective tax rate may be 15%. Just an unscientific estimate.)
  • Post-tax corpus with 10% tax and 4% cess: ₹40,07,389.
    • Tax owed is ₹1,16,929.
    • 2.84% of the final corpus is owed as tax.

Conclusions

To recap, these are the objective takeaways from the numbers.

  • Tax at 30% is significantly higher than 10% or 20%. (Of course!)
  • The higher the rate of return, the higher the taxes owed.
  • The higher the investment duration, the higher the taxes owed.

The more nuanced and subjective aspects are interesting to think about. For a 10 year debt SIP, if the tax difference is 8% of the corpus vs 13% of the corpus, the choice is easy for me: I’d pay the tax to keep my debt portfolio clean and simple. This is partly because I take barely any credit risk in my debt portfolio. High tax for a low-risk investment is fine.

Other asset classes are not so straightforward. Am I okay to invest in international equity and not be compensated for the risk (with a lower tax bill)? I don’t currently know what my stance is.

Hopefully, we can all think about these nuances and make the tradeoffs that we are comfortable living with.

9 Apr 2024

Random thoughts after our Bali visit

Some scattered thoughts from our recent visit to Bali, Indonesia:

Pura Tirta Empul in Bali
  • While I don’t hate my job, it probably is very stressful. I am not consciously aware of the stress, but my constant ailments pretty much disappeared during the trip, even when I had stopped taking the regular medicines.
  • One of the best things that happened during this trip was bonding with my (8 years old) son. I never thought I’d be able to connect with him at a different level, but this trip made that possible. This is itself reason enough to keep travelling with my children.
  • A day is 8 to 10 hours long. Be it work or leisure, it should be just that length. Adults in the party (my wife and I) were okay to stretch the days to 12 hours, but the children needed their “me” time. They had to put their feet up and watch their YouTube videos or run around playing in the hotel room before they’d go to bed. I need to remember this next time and limit the number of activities we pack into each day.
  • I have always found flight travel awful. Dragging 3 sleep deprived and dehydrated children through airport gates and immigration reaffirmed my dislike for flying.

25 Mar 2024

The sorry state of Indian banks

What do you expect a business to do? To add value to its customers’ lives and charge a fee for the value addition. A win-win arrangement where both the business and the customers voluntarily work together for their own benefit.

What do Indian bank employees do? They simply ask the customer for “favours” to benefit the business at the cost of the customer. (Just to be clear, I am talking in general about banks in India; not the entity named Indian Bank.)

This isn’t new; this has been happening for well over a decade now from what I have seen. Whenever I interact with bank employees, most of them push an insurance product. They don’t even pretend that they are helping me, the customer. They openly describe these as requests for favour.

My family members and I have received calls in the past few weeks from bank employees with requests to open fixed deposits so their branch’s balance sheet shows inflated numbers when the financial year ends. I opened a 10 days fixed deposit because I felt I could help a bank employee. That person knows that a 10 days fixed deposit doesn’t serve a meaningful benefit to anyone—neither to the bank nor to me. But still they were happy with my opening that deposit.

Our banks have been measuring the wrong things and incentivising the wrong things for a very long period. Until banks get serious about adding value to customers, our banks will stay as rotten as they are now.

Image credit: rawpixel.com

Until a meaningful positive change happens, I’d continue to repeat my advice: “Do not ever tell your bank that you have money to invest. They are uninterested in your desires and dreams. They only think about how they can transfer some of your money into their own coffers.”