Picture a client who walks into your office clutching a fact sheet, pointing at a Large-Cap fund that delivered 14% returns while its benchmark index returned 13%. The client assumes the fund manager is a genius, but as an MFD, your task is to determine whether that 1% ‘alpha’ is truly a result of superior stock selection or merely a byproduct of higher portfolio volatility. This is where Tracking Error and Information Ratio become your primary filters to separate genuine skill from random noise.
Tracking Error measures the deviation of the fund’s returns from its benchmark index over a specific period. A low tracking error suggests the fund manager is sticking closely to the benchmark, which is expected in index funds or passive strategies. However, in actively managed funds, some tracking error is necessary; without it, the manager cannot hope to outperform the market.
When you see a high tracking error in a fund that claims to be a conservative equity strategy, it serves as a red flag that the manager might be taking unintended risks to chase returns.
To normalize this, we use the Information Ratio, which effectively measures a manager’s consistency in generating excess returns per unit of tracking error. If a fund manager consistently delivers high returns but with wild, unpredictable swings relative to the index, the Information Ratio will remain low. For an MFD, this is a vital tool when discussing a fund’s value proposition with a retiree or a conservative investor.
It allows you to demonstrate that you aren’t just looking at the final percentage, but at the quality and reliability of the process that generated those gains.
When recommending a scheme, you are essentially vetting the manager’s ability to navigate market cycles. While direct plans offer lower expense ratios, they lack the behavioral hand-holding and granular suitability analysis you provide. By explaining the Information Ratio, you justify the regular plan’s cost by showing the client that you are identifying managers who provide consistent value, not just volatile spikes. This rigorous approach moves the conversation from mere sales to professional investment management.
Ultimately, think of Tracking Error as the ’noise’ in the signal, and the Information Ratio as the measure of the signal’s ‘purity’. A fund that beats its benchmark consistently while maintaining a disciplined tracking error is usually a sign of a robust investment process. Use these metrics to build transparency, ensuring your clients understand that long-term wealth is built on consistent performance rather than lucky streaks.
Nuance
Check Your Understanding
An MFD is evaluating two equity schemes with similar average returns over three years. Scheme A has an Information Ratio of 0.8, while Scheme B has an Information Ratio of 0.3. What should the MFD communicate to the client?
Which of the following scenarios best describes a situation where Tracking Error would be expected to be near zero?
This is a companion read for Section 11.1 — Benchmarks and Performance from Ace the NISM Mutual Fund Distributors Exam by Akhilesh Gururani, available on Amazon Kindle.
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