Exchange Traded Funds (ETFs)

The key participants in this market have traditionally been large institutional players looking to index core holdings or pursue more assertive market timing and sector rotation strategies. However, given that smaller institutions and retail investors can trade in modest quantities, they can essentially invest on the same terms as their larger counterparts.

For retail or wholesale investors with a long-term perspective, it enables portfolio diversification with a single investment. This shields them from the short-term trading activities of other investors in the fund, as ETFs employ a unique in-kind creation/redemption mechanism. The lower costs of ETFs enhance net returns over the long term.

For Foreign Institutional Investors (FIIs), institutions, and mutual funds, it offers straightforward asset allocation, hedging, and the ability to convert cash into equities at a low cost.

For arbitrageurs, it facilitates easy arbitrage between the cash and futures markets with low impact costs.

For investors with a shorter-term horizon, ETFs provide access to liquidity due to the ability to trade during the day and at values close to Net Asset Value (NAV).

Tracking error refers to the disparity between the returns of an ETF portfolio and the intended benchmark or index it aims to replicate or outperform.

Similar to other mutual fund schemes, ETFs and Index funds bear various expenses, encompassing areas such as marketing, advertising, office administration, brokerage, and more. These costs diminish the returns of the ETF. Additionally, the ETF may receive dividends from the underlying stocks, leading to temporary outperformance compared to the benchmark. This deviation in performance is commonly known as "tracking error," expressed as a percentage. Tracking error is also referred to as active risk. The adept management of inflows and outflows by an index fund plays a role in determining tracking error. A lower tracking error signifies superior performance for the ETF/Index fund.

Exchange Traded Funds (ETFs) aim to replicate the performance of a specific index or underlying security. However, there are instances where the ETF may deviate from replicating the returns, a phenomenon known as 'tracking error.'

Tracking error is characterized as the standard deviation of the difference between daily returns of the underlying benchmark and the Net Asset Value (NAV) of the Scheme.

Several factors can contribute to tracking error, including fund expenses, liquidity challenges for meeting redemption needs, and the time taken to reallocate the portfolio.

Fund managers consistently strive to eliminate or, at the very least, minimize tracking error.