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Previously, in this column, we discussed how Asset Management Companies (AMCs) can nudge investors in index funds to optimally take profit. Continuing this argument about helping investors improve their financial well-being, we discuss how AMCs can offer an index fund variant.
Allowing tracking error
Take a large-cap index fund benchmarked to the Nifty 50 Index. There are two reasons why an open-end index fund cannot mirror its benchmark returns. One, index fund charges a fund management fee and incurs trading cost to buy securities, whereas the index is simply a weighted average of the constituent stocks. So, the index fund’s returns will be dragged down by costs. And two, the index fund will hold some cash to meet redemption request. So, it will have 51 assets in its portfolio, including cash. Therefore, the weight of each stock will be lower than that of its corresponding weight in the index. If the index were to move up, the index fund will give a lower return. This is because the return generated on the cash will be lower than the returns generated on the stocks.
This is referred to as cash drag. The index fund also receives cash from investors who continually buy units in the fund, which the fund manager will invest in the index constituents. Suffice it to know costs of managing the fund and the cash drag will lead to the index fund returns being different from that of index returns.
Tracking error is the metric that captures this difference.
Now, let us differentiate between cash held for redemption purpose and cash inflow from investors. What if the index fund manager uses investor cash inflows to time purchase of the index constituents? This will allow the fund to generate a marginally higher return than a traditional index fund and, perhaps, neutralise fund costs. Call this a Tactical Index Fund as the fund manager engages in market timing to buy the index constituents.
Conclusion
The objective of a Tactical Index Fund is to cut active risk and yet improve returns over an index fund. It will have a larger tracking error than a comparable index fund. Active risk is the risk that an active fund will underperform its benchmark because of the security-selection bets taken by the fund manager. A Tactical Index Fund will not have such active risk, as the fund manager will invest only in the index constituents.
(The author offers training programmes for individuals to manage their personal investments)
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