Consider a client who reviews her Large-cap fund portfolio and asks why it lags behind the Nifty 50 by two percent despite the manager being highly paid. If you only look at total returns, you are ignoring the mechanics of how that fund is actually built. Understanding Tracking Error and Active Share is what separates a professional mutual fund distributor from someone who merely reads factsheets.
Tracking Error measures the consistency of a fund’s performance relative to its benchmark. A high tracking error indicates that the fund manager is taking significant deviations from the index composition, which can lead to periods of extreme outperformance or painful underperformance. For a conservative investor, high tracking error in a supposedly stable large-cap fund is a red flag that the manager is taking unintended risks that were never part of the original suitability mandate.
Active Share, conversely, tells you exactly how much of the portfolio differs from the benchmark index. If you recommend a diversified equity fund that boasts an Active Share of only 15 percent, you are essentially selling a ‘closet index’ fund that charges active management fees for passive-like results. When an MFD identifies a fund with high Active Share, they are identifying a manager with high conviction who is actively seeking to generate alpha through specific stock selection rather than merely mimicking the top 50 companies in the country.
Take the example of a Mid-cap fund compared against the Nifty Midcap 150. If the fund has a very low tracking error but also a very low active share, it is effectively just a shadow of the index. In such cases, the client might be better served by a low-cost passive product.
However, if the fund demonstrates a high active share with disciplined tracking error, it suggests the manager is skillfully deviating from the index to capture opportunities, justifying the additional expense ratio of a regular plan through the value of expert management and the ongoing guidance you provide.
When you present a fund to a client, explain that these metrics serve as a check on the ‘manager’s fingerprint’. You are not just looking for the highest return; you are looking for evidence that the manager’s strategy is being executed as promised. This technical rigor reinforces your value as an MFD, proving that you aren’t just selecting funds, but curating portfolios with a deep understanding of risk and mandate adherence.
Nuance
Check Your Understanding
An MFD is analyzing a Large-cap equity scheme that claims to be actively managed, but the data shows an Active Share of 8%. What should the MFD conclude regarding this scheme?
A client asks why their fund’s returns often fluctuate significantly away from the benchmark despite being in the same category. Which metric is the primary indicator of this volatility in performance relative to the index?
This is a companion read for Section 11.4 — Benchmarks for equity schemes from Ace the NISM Mutual Fund Distributors Exam by Akhilesh Gururani, available on Amazon Kindle.
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