Many portfolios are managed to a benchmark, typically an index. Investors buy index exchange traded funds (ETFs) and passive mutual funds to achieve the performance of a market index without incurring the fees associated with active stock picking.
Not all funds track their indexes as closely as others. The difference between a fund’s performance and the performance of the index it tracks is known as tracking error. Tracking error should influence your decision when it comes to the selection of a fund.
What is tracking error?
Tracking error is a measure of the difference between returns from a fund and it’s corresponding benchmark. The lower this number is the better, if the tracking error is high the fund manager has not taken the right level of risk, this is regardless of over or under performance.
Tracking error are mostly associated with passive investment vehicles. Typically, active funds are trying to achieve the best performance possible and beat inflation, whilst passive funds are trying to match the performance of a market.
Tracking error within an ETF
With an ETF you pay the management fee and the costs of trading and this is known as the total expense ratio (TER). Typically tracking error will be equal to the TER. An investor expects the ETF to perform in the same way as the index it tracks, this is because the ETF buys a slice of that market at the same weight as the index. If the index returns 10% and the TER is 50bps the ETF investor will receive returns of 9.5%.
The TER of ETFs is typically lower than other types of funds; this is one of the reasons MoneyFarm uses ETFs in portfolios. By ensuring costs or the TER is lower you ensure that the index is tracked more accurately.
In some situations, a fund does not hold all of the securities that make up the index, this can cause tracking error to be higher. For example, a global bond index could be made of 2,000 bonds, not all of these are traded and an ETF might hold 200 or so of these, it is not an exact replication. The ETF would replicate the same exposure but not the exact composition of the index. There are a number of reasons why an ETF may not hold all securities:
- Difficulties in creating and redeeming the shares
- Liquidity – some stocks are not liquid enough to be bought by a fund without impacting the stock price.
Why not invest in the original stock?
To remove tracking error completely an individual could try to replicate the index themselves by investing in the original stock. However, to replicate an index such as the FTSE100 in the same way as the ETF an individual would need around £100,000. With an ETF you could have a slice of the FTSE100 for £150. Not only this, but if you buy the stocks themselves you are then subject to stamp duty and this could impact your real returns.