scorecardresearchWhen multiple funds are tracking the same index or sector, why do their returns differ?

When multiple funds are tracking the same index or sector, why do their returns differ?

Updated: 24 Mar 2022, 08:38 AM IST
TL;DR.

Even while all funds tracking the same index aim to invest money in the same ratio as the underlying index, there can be some variance due to a number of factors. Although this variation is little, there can be a considerable difference in the returns posted by similar index funds. Let us discuss the factors responsible for this variation.

Index funds and exchange-traded funds (ETFs) that use different strategies to tailor their portfolios to match an index are likely to have varying returns.

Index funds and exchange-traded funds (ETFs) that use different strategies to tailor their portfolios to match an index are likely to have varying returns.

Index funds and exchange-traded funds (ETFs) that use different strategies to tailor their portfolios to match an index are likely to have varying returns. Indexing, or investing in funds or ETFs that closely match a certain stock or bond index, is a growing financial technique. Indexing's popularity has contributed to an increase in interest in exchange-traded funds, the majority of which track indexes.

All the funds which are linked to one index such as Nifty or Sensex are supposed to post the same returns. The two funds linked to S&P BSE Sensex ideally should post the same gain which Sensex posted in that particular year and likewise, the funds tracking Nifty50 should ideally match the returns of Nifty50. But it doesn’t actually happen. For instance the two funds tracking Sensex — HDFC Index Fund Sensex Plan and ICICI Prudential Sensex Index Fund — tend to post different returns.

In reality, a variety of variables contribute to certain funds or ETFs tracking their indexes more closely than others. Even while all funds following the same index attempt to invest money in the same ratio as the underlying index, a little variation tends to occur due to a variety of factors including retaining cash for contingencies, changes in the index's composition, and so on.

Although this variation would not be major, there is a significant variation between identical index funds from other asset management companies. Let us discuss the reasons for the same.

When different funds are tracking the same index, following factors cause difference in fund returns:

Expense Ratio

Managing an index fund or index ETF necessitates the fund firm paying a manager to acquire the securities in that index, in addition to the administrative costs of document, client support, and so on. Index funds and ETFs transfer these expenses on to its consumers in the form of commissions, some of which are made clear through the fund's specified expense ratio whereas others, such as brokerage charges, are less visible. The methodologies used to create funds, as well as activities such as securities borrowing, can have an influence on the returns actually gained by fund investors.

Entry and exit loads

Entry and exit loads are charges levied on mutual fund investments and withdrawals. SEBI has eliminated entry loads for mutual funds. These fees are levied to prevent investors from making early withdrawals. They have no effect on the fund's return per se, but they do have an effect on the investor if he chooses to withdraw contributions within the stipulated time frame. In general, funds charge an exit load of 1% of the amount withdrawn if it exceeds a certain proportion of the investment before a certain time .

Tracking Error

The tracking error is the difference between the fund's return and the benchmark's return. Tracking errors are often evaluated against the entire returns for the given benchmark, that comprises dividend payouts. Investing in funds with low tracking error is preferable. Good tracking error is defined as having a lower tracking error.

One of the major causes of tracking error is that mutual funds often hold a portion of their assets in the form of cash to finance withdrawals. Inflows may also occur as a result of business acts such as dividends, etc.

When different funds are tracking the same sector?

Funds are managed by portfolio managers who thoroughly assess stock market circumstances before taking a calculated risk by investing in firms with great potential. Other funds, on the other hand, track the patterns of certain market indexes, investing solely in firms that are increasing in the rankings.

The disparity in returns is related to how various funds allocate their resources. A and B, for example, are two firms in the same sector. One fund invests 30% of its resources in business A and 70% in firm B. Another fund invests evenly in both firms, putting half of its money in A and the other half in B. If Company A's stock outperforms Company B's stock, both funds will receive different returns despite investing in the same sector.

As we summarise, we can reiterate that the expenses of the underlying assets in the pool of resources determine how much an ETF's share price changes. When the price of one or more assets rises, so does the price of the ETF's shares, and vice versa.

The value of the dividend received by ETF shareholders is determined by the ETF company's performance and asset management. Due to a variety of factors such as tracking error, resource allocation, and cost and expense differences, tracking the same sector or index might yield different results.

 

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First Published: 24 Mar 2022, 08:38 AM IST