SEBI: Tracking Error of Equity ETFs and Index Funds Cannot Exceed 2%
Moneylife Digital Team 24 May 2022
The tracking error for equity exchange traded funds (ETFs)/index funds cannot exceed 2% and the tracking difference for debt funds—averaged over one year—must be within 1.25%, as per the recent circular of the Securities and Exchange Board of India (SEBI) on passive mutual fund (MF) schemes.
The circular is titled ‘Development of Passive Funds’ and considered the recommendations of the mutual funds advisory committee (MFAC) on the back of growing interest for passive investment products that are characterised by transparency, diversification and lower cost compared to active MF schemes.
The tracking error is the annualised standard deviation of the difference in daily returns between the underlying equity index and the NAV of the ETF/ index fund based on past one-year rolling data and must be within 2% levels. This metric measures how well the fund generates returns vis-a-vis the target index’s returns.
As per the circular, all ETFs/ index funds (including debt ETFs/ index funds), must disclose the tracking error based on the past one-year rolling data, on a daily basis, on the website of respective asset management companies (AMCs) and Association of Mutual Funds of India (AMFI), according to the SEBI circular.
Note that for schemes in existence for a period of less than one year, the annualised standard deviation shall be calculated based on available data.
In addition to the tracking error, passive MF schemes  must also disclose ‘tracking difference’ on a monthly basis. The difference between the index product’s return from that of its benchmark index as on a particular date is called tracking difference.
Tracking difference has to be disclosed for tenures of 1-year, 3-years, 5-years and 10-years and since the date of allotment of units.
Tracking difference is capped for debt ETFs/index funds to 1.25%. “For Debt ETFs/ Index Funds the annualized tracking difference averaged over one-year period shall not exceed 1.25%," stated the SEBI circular.
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