Tracking Error Explained for Mutual Fund Investors

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Index Fund Center

Tracking Error Explained for Mutual Fund Investors

Aaron Levitt Dec 04, 2014

With actively managed mutual fund returns not being up to snuff, and—-for the most part—significantly underperforming the market during the last decade or so, many investors have turned towards index funds as a way to gain better returns. After all, what’s not to like about index funds? Low cost, passive management, low relative tax bills and market matching performance are all hallmarks of the mutual fund type.
Except performance does not always match the market. In fact, ALL index funds don’t actually match their benchmark indexes. That’s because index funds suffer from what’s called tracking error. Understanding this concept and how it relates to returns is vital when figuring out how to pick the correct index mutual fund.

Be sure to also see the 25 Tips Every Mutual Fund Investor Should Know.

What Exactly Is Tracking Error?

Every index fund tracks a benchmark index. Whether that’s something as simple as the broad S&P 500 or more complex, like the NASDAQ OMX Global Water Index, index funds follow a certain set basket of stocks. This is essentially what makes them index funds. The problem is that you can’t invest directly in an index; you have to physically go out and buy all the stocks in the benchmark.

See also Do Mutual Fund Benchmarks Matter?.

This fact helps create and drive an index fund’s tracking error. Tracking error is the difference between a mutual fund portfolio’s returns and the benchmark index it was designed to copy. Generally, tracking errors are calculated against the total returns for the specific benchmark—which includes dividend payments—and are reported as a “standard deviation percentage” difference.

For example, if you buy shares in ABC Investments’ S&P 500 mutual fund, which is designed to track the venerable S&P 500, and it returns 5.0% while the S&P 500 returns 5.5%, ABC Investments’ fund has a 0.5% tracking error.

There are several reasons for why an index fund will underperform or—in rare occurrences—outperform their benchmarks. First, all mutual funds hold some cash on their books. This is to help pay out investor redemptions as well as manage inflows into the fund. By holding some cash, the fund is not 100% fully invested in the indexes’ underlying holdings. This cash cushion creates a drag on overall performance.

The biggest drag on performance is usually the fund’s expenses. The expenses we pay to own a mutual fund come out of the fund’s profits and assets, and reduce its overall performance. For example, if the previously mentioned ABC Investments S&P 500 fund charges 0.20% in expenses and the S&P 500 Index returns 10.00%, under a best case scenario, the fund will only return 9.80%. When you add in other fees like front-end sales loads and 12b-1 fees, you are starting to really deviate from the underlying index’s performance.

Be sure to check out the Cheapest Mutual Funds for Every Investment Objective.

Additionally, if an index fund uses a sampling strategy to derive its holdings, it can result in a larger than normal tracking error. In a sampling strategy, the mutual fund will buy most, but not necessarily all, of the stocks within the benchmark index. The idea is that the fund will attempt to closely match the overall investment attributes of the index. A fund manager will make the selections to keep sector weightings and provide a large spread of firms to cover the underlying index. Unfortunately, if the manager “bets” wrong, the fund could have a big tracking error.

How Investors Can Use Tracking Error

Now that we know that all index funds have some sort of a tracking error, we can use the statistic to find the best index funds around. A fund with a low tracking error means its portfolio is closely following its benchmark; one with a high tracking errors indicates the exact opposite. If you’re trying to buy the S&P 500, sticking to a fund with a lower tracking error is the best strategy to get as close to the index’s returns as possible.

Index funds that use a full replication strategy and low expenses—meaning without sales loads—will generally have lower tracking ratios. Therefore, these funds will match their benchmarks more closely. You can compare similarly styled funds to see which ones are better indexers.

Tracking “error” also relates to actively managed mutual funds as well. All mutual funds will select a benchmark that they seek to outperform. Tracking error calculations can be used to see just how much the fund manager is “different” than the fund’s underlying benchmark. That can be used to weed out closet indexers and help investors get more bang for their investment buck.

The Bottom Line

As investors have flocked to index funds to round out their portfolios, but many don’t understand just how the concept of tracking error could be tampering with their returns. This deviation from a fund’s underlying index is a fact of life, but it can be maintained and limited. By selecting funds with low tracking errors, investors can more closely match the indexes they choose.

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