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Tracking error: How to measure it and what it tells us

The ideal method for comparing the cost of index trackers is tracking error not the commonly cited but flawed Total Expense Ratio (TER).

Tracking error enables you to dig beneath superficial differences in TER to unmask deeper cost divides between tracker funds.

These cost gulfs can have a significant impact on your eventual returns, as demonstrated by doing a tracking error comparison between three of Britain’s cheapest FTSE All-Share trackers.

But how important is this information, and how can you conduct tracking error comparisons with your own funds?

Read on! But before you do, please check out that FTSE tracker comparison, and take a look at this piece about tracking difference.1

To briefly recap our previous results, we analysed the returns of three FTSE All-Share trackers against their benchmarks:

FTSE All-Share trackers compared against their benchmark.

The Vanguard fund was the clear winner with a tracking error of 0.07% in the last year. The HSBC fund came in a distant second (0.5%), and the Fidelity fund trailed in dead last (0.82%).

How to decide if you are in the wrong fund

So is that job done? Should passive investors across the nation stampede out of their Fidelity FTSE All-Share trackers and into Vanguard’s?

AHAHAHAHAHA! You and I both know it’s never so simple. Where’s the fun in a straightforward decision like that?

Here’s the pros and cons of leaping into action based on the result of our tracking error comparison.

Pros:

  • The Vanguard fund bastes its rivals by similar margins in both years that data is available for.
  • Vanguard rebalances its fund more frequently to help it stay true to the index. (Vanguard rebalances daily, HSBC quarterly, and Fidelity when the index rebalances).
  • Vanguard lends out the fund’s underlying stocks to other market operators. This practice earns commission for the fund that reduces its overall cost and thus its tracking error. Vanguard’s policy enables it to lend out 100% of the fund’s stocks.
  •  All of the stock-lending proceeds are returned to the fund – Vanguard doesn’t snaffle any of the upside for the management company’s profit at the expense of its investors. This is so generous, it makes the Good Samaritan look like a git.
  • 100% of the Vanguard fund’s stocks may be lent. This is good if you like having your costs reduced, but bad if you’re not so keen on stock-lending risk.
  • HSBC will lend up to 70% of its fund’s stock, but it only returns 75% of the proceeds to the fund. The rest goes to HSBC, even though it’s the investors who are on the hook if HSBC can’t get the stocks back.

Cons:

  • Tracking error is unlikely to stay constant year in, year out.
  • Only two years of data is available for the Vanguard fund. Ideally we’d have five.
  • If you’d rather your fund doesn’t hawk out its assets for money then go for Fidelity – it doesn’t lend out any stock from the fund.
  • Comparison data may not be 100% reliable.

Tracking error DIY guide

Rather than me clouding the issue with pros and cons and ifs and buts, it might help you to decide if you recreate your own tracking error play-offs.

You can do this by comparing index trackers against their benchmark returns on your favourite chart comparison tool.

Compare tracking error with a charting tool

I used Hargreaves Lansdown’s charts because they are fabulously user-friendly and they present the returns information in a ready-to-eat table format:

  • Search for a fund on Hargreaves Lansdown and click through to its ‘Overview’ page.
  • Click on the ‘Charts and performance’ tab.
  • Go to ‘Add to chart’ and add your index.
  • Add your funds, making sure you click on the right version. E.g. Acc for accumulation units and Inc for income units.
  • Also look out for R or Ret for retail funds, as opposed to Inst for institutional funds.
  • Add ETFs by clicking on Equity in the ‘Choose your investment’ section.
  • Type in the three or four letter ticker symbol for the ETF. e.g. ISF2. (You’ll find the symbol on the ETF’s factsheet.)
  • Compare your tracker’s year-by-year returns and cumulative returns against the index.
  • Tracking error equals the difference between the index’s return and your tracker’s return.

Obviously the tracker that hugs the index the closest is doing the best job.

In fact, even if your fund is trouncing its index then you’ve got problems, because it’s not doing the job you’ve bought it for. As with mutants, for trackers any deviation is bad.

Make sure you’re comparing the tracker against the index referenced as its benchmark on its factsheet – otherwise the comparison is unfair.

Note that there are even different versions of the same index. So choose the Total Return flavour if you reinvest your dividends, the Price Return index if you don’t.

Tracks of my tears

Plotting tracking error comparisons can be more frustrating than trying to penetrate a call centre telephone menu while The Entertainer plays on perpetual loop.

Matching up FTSE All-Share trackers is reasonably easy because the FTSE All-Share index is recognised by the financial tools available to retail investors.

You are equally in luck if you want to compare against the FTSE 350 Beverages index or the Oslo All-Share.

But comparing emerging market trackers against the MSCI Emerging Markets index? Forget it. Trustnet won’t let you do it, nor Morningstar, Yahoo Finance, or Hargreaves Lansdown. Google Finance will but the results are laughably wrong.

The best I’ve managed in these situations is to plot fund returns against each other to see how synchronised they are, then compared that with published factsheets to see how tightly each fund usually performs against its benchmark.

At least that enables me to see the differences in fund performance, and I can estimate how effectively they track the index. It’s not great but it’s the best I can find right now. If anyone knows better I’d love to hear from you.

There are plenty of factors to consider when choosing a tracker but tracking error is the most important, which makes it a mighty shame that it’s so hard to get clean data for many indices.

Acting on tracking error data is partly a judgement call, partly guesswork, partly deciding on your own tolerance levels.

Personally, if I know I can buy something for half the cost elsewhere then it’s time to swing into action.

Take it steady,

The Accumulator

  1. I am referring to tracking difference as tracking error in this piece because that is common parlance. []
  2. iShares FTSE 100 []

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{ 14 comments… add one }
  • 1 saveonarola February 28, 2012, 1:08 pm

    Great stuff, Accumulator.

    Having chosen Vanguard for their investor-friendly outlook, I must say I’m a bit unnerved by this stock-lending business (which I was ignorant of when I bought my Vanguard funds). Presumably Vanguard is aware that its counter-parties probably include lots of effectively bankrupt financial institutions. What happens when the SHTF?

  • 2 57Andrew February 28, 2012, 2:33 pm

    @saveonarola, I suspect Vanguard does analyse counterparty risk and hopefully in some detail, But that will never prevent fat tail events – low probability, high impact. Diversification is sensible up to a point. But it needs to be across asset classes. For example if I run a fund of 20 stocks I may arguably be reasonably well diversified (in equities) but when as you say the SHTF everything tends to be highly correlated. Personally I own bricks and mortar, hold cash, run my own pension fund which itself is a blend of stocks, bonds, ETFs and cash and I run a very small position in physical gold. I don’t worry about one of my ETFs crashing because of stock lending. If it happens it won’t torpedo me. I don’t use synthetics. I also avoid anything with a wide bid-offer spreads and low volumes. Essentially after some property I look for liquidity. I do have a small proportion of my pension fund in structured notes and I can tell you I worry more about the counter-party risk on those than I do about my ETFs. I understand the risks but many, many people don’t.

  • 3 harry February 28, 2012, 2:50 pm

    @ The Accumulator,

    ‘This is so generous, it makes the Good Samaritan look like a git.’

    That made me laugh, thanks.

  • 4 saveonarola February 28, 2012, 4:18 pm

    @57Andrew

    Agree wholeheartedly about the importance of diversification. In addition to equities, I also have cash, bonds, a little bit of physical gold and the equity in my property. However, my entire investment in equities is in two Vanguard LifeStrategy funds – after all, that’s precisely how those funds are designed to be used, as a diversified portfolio in one fund – so I can only hope that Vanguard diversifies its own risk accordingly.

  • 5 gadgetmind February 28, 2012, 8:35 pm

    Here is Vanguard’s PDF regards securities lending, along with whys and wherefores.

    https://www.vanguard.co.uk/documents/adv/literature/securities-lending-still-no-free-lunch.pdf

  • 6 john February 28, 2012, 9:18 pm

    I imagine some of Vanguard’s outperformance of its peers is also due to the dilution levy applied (0.5% on purchases in the case of the Vanguard FTSE UK Equity Index), which is paid by the transacting individual and becomes part of the property of the fund. The dilution levy is used to offset the costs of creating and cancelling units, and the ensuing costs to the fund of buying or selling underlying securities accordingly, rather than being retained by Vanguard as would be the case with an initial charge. In effect, and in contrast to other funds without a dilution levy, the transacting individual bears the costs of their transactions, rather than the costs being borne by the fund (and therefore all of its unitholders equally) through a reduction in the unit price (which then shows up in the tracking error relative to the index).

    I wonder though how the Vanguard trackers’ daily rebalancing reflects itself in the tracking error, as I’d have thought that while the fund should always much better reflect the index it’s tracking, that’d mean an awful lot of dealing in the underlying securities relative to funds that rebalance less often. Any thoughts on the tradeoff there and whether it actually increases or reduces tracking error?

  • 7 Alex March 1, 2012, 7:04 pm

    Be careful over at HL’s website – don’t end up ensnared: they’re rather keen on ‘expert’ fund managers, for some reason… 😉

  • 8 The Accumulator March 1, 2012, 10:23 pm

    @ John – it would be interesting to compare the portfolio turnover rates of the 3 funds to see what difference the rebalancing methods make to churn. It’s also possible that the three fund managers don’t pay the same price for transactions.

    @ Alex – quite right, lead us not into temptation…

  • 9 saveonarola March 4, 2012, 3:51 pm

    @gadgetmind

    Thanks for that link. Interesting stuff.

  • 10 dean March 11, 2012, 4:27 am

    Have a go on Bloomberg’s charting tool. It happily let me plot a number of emerging market index and fund results. E.G. i was able to plot MXEF:IND the msci emerging markets price index and NDUEEGF:IND the msci daily total return net emerging markets us dollar index against the following funds: ishares large cap emrg..mkts., IEEM:LN, ishares smallcap emrg…mkts., IEMS:LN and Legal & General emrg..mkts., fund, KSF1:LN. You need the suffixes :LN for funds and :IND for indexes to make the charting tool work. Didn’t try any other emerging market funds. Good luck.

  • 11 The Accumulator March 12, 2012, 10:04 pm

    Great stuff, Dean. Thanks for the heads up. Where did you get the code from for the L&G Global Emerging markets fund – I’m assuming this is the index fund? I’ve just had a look at the factsheet and it only lists ISIN and SEDOL codes.
    Also, how are you checking which version of the index you’re charting?

  • 12 Geo June 1, 2012, 8:17 am

    Last week (25th may 2012) Moneyweek had a tiny mention of HSBC Asia Pacific Index (an accumulator favourite?) and said it had underperformed the index by 50% over 10 years. As mentioned it is almost impossible to track this online though, I think I did confirm it on Fool in the end, but HL don’t even have the MCSI Asia Pacific on their index list. As an investor in this fund this is quite a shock although I cant say many managers seem to do that much better – their are some but who knows what will happen in the next 10 years.

    Anyone seen that Interactive Investor is now going to charge £30 a quarter? Any thoughts. I’m sure it might pop up here soon.

  • 13 Geo June 1, 2012, 8:18 am

    Oops £20 not £30

  • 14 gadgetmind June 1, 2012, 9:57 am

    @Geo – that HSBC tracker used to have high fees before Vanguard came along, but they have now lowered them to be a bit more competitive. However, even taking that into account, that tracking error sounds bogus.

    But it is a good lesson regards fees: it’s not indexing that makes trackers so good but the low fees. Add high fees to a tracker and it will underperform just like the majority of high fee active funds.

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