As an investor, you may have heard of the many benefits of passive investing, particularly in index funds. After all, index funds are designed to track the performance of a specific market index, providing investors with a diversified portfolio at a low cost. However, there's one crucial factor that could be affecting your returns: index tracking error. It's a concept that's often overlooked, but it could be costing you thousands of dollars in missed opportunities. In this article, I'll dive into what index tracking error is, why it matters, and how you can minimize its impact on your portfolio. So, if you're ready to take your passive investing strategy to the next level, keep reading.
Key Takeaways (a short summary)
- Tracking error measures the deviation between the price behavior of a portfolio and a benchmark, and can negatively impact investment returns and increase risk and volatility.
- To minimize tracking error, investors should choose index funds with low expenses and low tracking error, monitor the tracking error, and consider enhanced index funds.
- Tracking error can offer opportunities for outperformance, cost savings, and diversification, but investors should be aware of potential drawbacks and factors affecting tracking error.
- When choosing an index fund, consider the benchmark index, company size and capitalization, expense ratio, investment goals, diversification, index fund provider, limitations or restrictions, asset allocation plan, and risk.
- Understanding tracking error and tracking difference is crucial for investors to make informed decisions about index fund investments.
Understanding Index Tracking Error
When investing in index funds, it's essential to understand tracking error. Tracking error is a measure of the deviation between the price behavior of a position or a portfolio and the price behavior of a benchmark.
In the context of index funds, tracking error indicates how well the fund tracks the benchmark index during the investment tenure.
What is Tracking Error?
Tracking error is the annualized standard deviation of daily return differences between the total return performance of the fund and the total return performance of its underlying index. In other words, tracking error measures the volatility in the difference of performance between the fund and its index.
A low tracking error signifies that the portfolio closely follows its benchmark index, while a high tracking error signifies that the portfolio is not following the benchmark.
Calculation of Tracking Error
To calculate tracking error, use the following formula: Tracking Error = Standard Deviation of (P - B), where P is portfolio return and B is benchmark return. The simple way to calculate tracking error is to take the fund's performance and subtract the benchmark index performance.
Tracking error is reported as a standard deviation percentage difference, which reports the difference between the return an investor receives and that of the benchmark they were attempting to imitate.
Interpretation of Tracking Error
A small tracking error indicates that the fund does not significantly outperform the benchmark, while a large tracking error indicates that the fund is not tracking the benchmark closely. Factors that can affect a fund's tracking error include the extent to which a fund's holdings match the holdings of the underlying index or benchmark, differences in weighting between a fund's assets and the assets of the index, and illiquid or thinly-traded securities.
Why Tracking Error Cannot Be Zero
Please note that tracking error in index funds cannot be zero because of expense ratio, fund cash flow, and portfolio realignment due to changes in index composition. The reasons for tracking errors in index funds include mutual fund expenses, cash balance of index funds, and problems in buying/selling underlying index stocks.
Tracking error is a measure of the relative risk of an investment portfolio as compared to its benchmark index.
Causes and Effects of Index Tracking Error
Causes of Tracking Error
1. Mutual Fund Expenses: One of the primary causes of tracking error is mutual fund expenses. These expenses can include costs associated with buying and selling stocks, fund management expenses, and fund administration charges. Higher expenses lead to higher tracking error.
2. Cash Balance of Index Funds: Another cause of tracking error is the cash balance of index funds. An index fund may receive an inflow of cash due to a sudden increase in investment or payout of dividends by stocks in its portfolio. In such cases, the fund manager may take some time to reinvest this money, which can contribute to an increase in tracking errors.
3. Problems in Buying or Selling Underlying Index Stocks: Tracking errors may also be caused due to a scheme's inability to buy or sell the underlying index stocks. This problem usually occurs due to low liquidity or sudden market movements, which increase the volatility of specific stocks.
4. Differences in Holdings and Weighting: Many funds are made up of just the fund manager's idea of a representative sample of the securities that make up the actual index. There are frequently also differences in weighting between a fund's assets and the assets of the index.
5. Illiquid or Thinly-Traded Securities: Illiquid or thinly-traded securities can also increase the chance of a tracking error, since this often leads to prices differing significantly from market price when the fund buys or sells such securities as a result of larger bid-ask spreads.
Effects of Tracking Error
1. Adversely Affects Investment Returns: Tracking errors tend to be small, but they can still adversely affect investment returns. Even small differences in tracking error can add up over time and result in significant differences in returns.
2. Higher Volatility and Risk: Higher tracking error can lead to higher volatility and risk in the investment portfolio.
3. Impact on Accuracy of Risk Measurements and Performance Evaluations: Tracking error can also impact the accuracy of risk measurements and performance evaluations.
Investors should investigate the tracking error of any index fund before investing in it. While most of the time the tracking error of an index fund is small, a variety of factors can sometimes conspire to open a gap of several percentage points between the index fund and its target index.
Therefore, investors should understand how tracking errors may develop and how to protect against them.
Managing Index Tracking Error
Investing in index funds is a popular way to diversify your portfolio and gain exposure to a broad market. However, it's essential to understand that index funds do not always track their benchmark index perfectly.
This is where tracking error comes into play.
What is tracking error?
Tracking error is a measure of the variability of performance of an index fund from its respective benchmark. It indicates how well the index fund tracks the benchmark index during the investment tenure.
A low tracking error signifies that the portfolio closely follows its benchmark index, while a high tracking error signifies that the portfolio is not following the benchmark.
However, a tracking error in index funds cannot be zero because of expense ratio, fund cash flow, and portfolio realignment due to changes in index composition.
Causes of tracking error
The tracking error in index funds arises due to various reasons such as mutual fund expenses, cash balance of index funds, and problems in buying/selling underlying index stocks. Mutual fund expenses such as costs associated with buying and selling stocks, fund management expenses, fund administration charges, (along with others) can lead to higher tracking error.
Tracking errors may also be caused due to a scheme's inability to buy or sell the underlying index stocks, which usually occurs due to low liquidity or sudden market movements that increase the volatility of specific stocks.
Illiquid or thinly-traded securities can also increase the chance of a tracking error, since this often leads to prices differing significantly from market price when the fund buys or sells such securities as a result of larger bid-ask spreads.
Evaluating portfolio managers
From an investor's point of view, tracking error can be used to evaluate portfolio managers. If a manager is realizing low average returns and has a large tracking error, it is a sign that there is something significantly wrong with that investment and that the investor should most likely find a replacement.
However, there is no universally accepted level of tracking error that is considered acceptable.
The acceptable level of tracking error may vary depending on the investor's investment objectives, risk tolerance, and investment horizon.
Minimizing tracking error
To minimize index tracking error in your portfolio, you can take the following steps:
- Choose an index fund with low expenses: Mutual fund expenses such as buying and selling stocks, fund management expenses, and fund administration charges can lead to higher tracking errors. Therefore, it is ideal to invest in a fund that has low expenses to minimize tracking error.
- Select index funds with low tracking error: While choosing an index fund, please invest in a fund that has a low tracking error. One way to select index funds can be by assigning a higher weightage to the funds whose tracking error is lower than the average of all other schemes using the same benchmark.
- Understand the causes of tracking error: Tracking errors can occur due to mutual fund expenses, cash balance of index funds, and problems in buying/selling underlying index stocks. Understanding these causes can help you make informed decisions while investing in index funds.
- Monitor the tracking error of your index fund: Please monitor the tracking error of your index fund to ensure that it is tracking the benchmark index closely. If the tracking error is consistently high, it may be time to consider switching to a different index fund.
- Consider enhanced index funds: Enhanced index funds have tracking errors below 4%, making it easier to establish skill for enhanced index fund managers.
- Understand tracking error and tracking difference: Tracking error looks at the volatility in the difference of performance between the fund and its index. Tracking difference, on the other hand, looks at the difference in returns between the fund and its index over a period of time. Understanding these concepts can help you make informed decisions while investing in index funds.
Why Portfolio Rebalancing is Crucial in Minimizing Index Tracking Error
When investing in index funds, it's crucial to keep an eye on index tracking error - the difference between the performance of the fund and the underlying index it's meant to track.
One way to minimize this error is through portfolio rebalancing.
This involves regularly adjusting the holdings in your portfolio to maintain a certain asset allocation that aligns with your investment goals.
By doing so, you can ensure that your portfolio doesn't become too heavily weighted in one area, which can lead to higher tracking error.
It's important to note that rebalancing too frequently can result in higher transaction costs and potentially lower returns, so finding the right balance is key.
Be sure to consult with a financial advisor to determine the best rebalancing strategy for your portfolio.
For more information:
Maximize gains with portfolio rebalancing
Benefits and Comparison of Index Tracking Error
Benefits of Tracking Error
While tracking error is generally considered a disadvantage, there are some potential benefits to tracking error in index funds.
Opportunities for Outperformance
If an index fund has a positive tracking error, it means that it is outperforming the index it is tracking. This can be beneficial for investors who want to achieve higher returns than the index.
Lower Costs
Index funds are generally low-cost investments, and tracking error can be an indication of how efficiently the fund is being managed. A lower tracking error can mean that the fund is being managed more efficiently, which can result in lower costs for investors.
Diversification
Index funds provide investors with exposure to a broad range of companies and sectors, which can help to diversify their portfolio. Tracking error can be an indication of how well the fund is tracking the index, which can help investors to ensure that they are getting the diversification they need.
Drawbacks of Tracking Error
However, tracking error can also be a disadvantage for investors, as it can result in underperformance relative to the index. Additionally, while index funds are generally considered low-risk investments, there is still a risk of loss, although it is relatively low.
Finally, while index funds have been a popular investment strategy for many years, some experts have raised concerns about the potential risks associated with over-reliance on index funds.
Factors Affecting Tracking Error
Index tracking error is a measure of the variability in the performance of an index fund. It is the difference between the performance of the fund and its benchmark index. There are several reasons why tracking error can differ between different types of index funds, including:
- Mutual Fund Expenses: Higher expenses lead to higher tracking error.
- Cash balance of Index Funds: If an index fund has a high cash balance, it can lead to tracking error.
- Problems in buying/selling underlying index stocks: This can lead to tracking error, especially in sectoral or thematic funds.
Impact of Tracking Error
A low tracking error signifies that the portfolio closely follows its benchmark index, while a high tracking error signifies that the portfolio is not following the benchmark. Tracking error cannot be zero because of expense ratio, fund cash flow, and portfolio realignment due to changes in index composition.
Tracking error can have an unexpected material effect on an investor's returns, so please investigate this aspect of any index fund before committing any money to it.
Reporting of Tracking Error
Fund houses may be selective in reporting tracking errors, so investors should look closely at the monthly factsheets of different fund houses. Tracking error is reported as a standard deviation percentage difference, which reports the difference between the return an investor receives and that of the benchmark they were attempting to imitate.
Beyond fund fees, a number of other factors can affect a fund's tracking error, such as the extent to which a fund's holdings match the holdings of the underlying index or benchmark.
Comparing Index Tracking Error
To compare index tracking error between different index funds, you can follow these steps:
1. Look for the tracking error of each index fund: Tracking error is the difference between the returns of the index fund and its benchmark index. It is reported as a standard deviation percentage difference. You can find this information on the fund's factsheet or website.
2. Take into account the difference in tracking error reporting: Some fund houses may be selective in reporting tracking errors. To compare index funds on the basis of tracking error, you should take into account this difference.
3. Calculate the tracking error yourself: If you want to be more precise, you can download the historical NAV data from the fund house website and then calculate the tracking error yourself using a spreadsheet.
4. Consider other factors that can affect tracking error: Beyond fund fees, a number of other factors can affect a fund's tracking error, such as the extent to which a fund's holdings match the holdings of the underlying index or benchmark. Illiquid or thinly-traded securities can also increase the chance of a tracking error.
5. Look for index funds with low tracking error: You can compare index funds based on their tracking error to find the ones with the lowest tracking error. A lower tracking error signifies better performance.
Other Factors to Consider When Choosing an Index Fund
When it comes to investing in index funds, there are several factors to consider. While index tracking error is important, it's not the only thing you should keep in mind. Here are some other factors to keep in mind when choosing an index fund.
Choice of Benchmark Index
The benchmark index that an index fund tracks can impact returns in several ways. For example, some indexes may be more volatile than others, which could impact your returns. Additionally, some indexes may be more heavily weighted towards certain sectors or companies, which could impact your diversification.
It is fundamental to understand the characteristics of the benchmark index before investing in an index fund.
Company Size and Capitalization
Index funds can track small-, mid-, or large-cap indexes. Small-cap indexes tend to be more volatile and have higher growth potential, while large-cap indexes tend to be more stable and have lower growth potential.
It is fundamental to understand the characteristics of the companies in the index before investing in an index fund.
Expense Ratio
While expense ratios should not be the only criteria used when choosing an index fund, they are still an important aspect to consider. Expense ratios can impact your returns over time, so please choose an index fund with a low expense ratio.
Investment Goals
Before investing in index funds, please know what you want your money to do for you. If you're looking to make a lot of money quickly and are willing to take on a lot of risk, individual stocks or cryptocurrency may be a better option.
However, if you're looking to let your money grow slowly over time, index funds may be a great investment for your portfolio.
Diversification
Index funds can help diversify your portfolio by spreading your investment risk across the stocks or bonds of many different individual companies. This can help reduce your overall risk and increase your potential for long-term returns.
Index Fund Provider
The index fund provider and their reputation should also be considered when choosing an index fund. Look for a reputable provider with a track record of success.
Limitations or Restrictions
Check if there are any limitations or restrictions on an index fund that prevent you from investing in it. For example, some index funds may require a minimum investment or may only be available to accredited investors.
Asset Allocation Plan
Index funds work quite well as part of an asset allocation plan. Index funds offer purity within their investment styles, so many financial advisers put together portfolios that include both index funds and actively managed funds.
Owning an index fund does not mean you are immune from risk or losses if the markets take a downturn. Please understand the risks associated with investing in index funds. It is fundamental to have a diversified portfolio that includes a mix of different asset classes to help reduce your overall risk.
Concluding thoughts and considerations
So, you want to invest in index funds? Great! But before you jump in, let's talk about something that can affect your returns: index tracking error.
Index tracking error occurs when an index fund doesn't perfectly match the performance of its benchmark index. This can happen for a variety of reasons, such as fees, trading costs, and imperfect replication of the index.
But what does this mean for you as an investor? Well, it could mean that your returns are lower than expected, or that you're not getting the diversification benefits you thought you were.
So, how do you manage index tracking error? One way is to choose index funds with lower expense ratios and trading costs. Another is to look for funds that use full replication instead of sampling to track their index.
But here's the thing: index tracking error isn't necessarily a bad thing. In fact, some degree of tracking error can actually be beneficial. For example, if an index fund is underweight in a particular sector that experiences a downturn, the fund's returns may be less affected than if it had perfectly tracked the index.
When choosing an index fund, please consider not only tracking error, but also other factors such as the fund's size, liquidity, and tax efficiency.
So, what's my unique perspective on index tracking error? Well, I think please remember that investing is never a perfect science. There will always be some degree of uncertainty and unpredictability. But that's also what makes it exciting.
Ultimately, the key is to do your research, diversify your investments, and have a long-term perspective. And remember, investing is a journey, not a destination.
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Links and references
- 1. "Techniques for Managing Tracking Error"
- 2. "Index-Tracking Optimal Portfolio Selection"
- 3. "ETFS – performance, tracking errors and their determinants in Europe and the USA"
- 4. "Index fund tracking error screener April 2023"
- 5. "Investment Profile Vanguard Advisors"
- 6. "Comparison of ETF´s performance related to the tracking error"
- northwestern.edu
- investopedia.com
- corporatefinanceinstitute.com
- scripbox.com
- etmoney.com
- evidenceinvestor.com
My article on the topic:
Passive Investing: Index Fund Basics
Recording for myself: (Article status: plan)