- Monevator - https://monevator.com -

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

The ideal method for comparing the cost of index trackers is tracking error [1] not the commonly cited but flawed Total Expense Ratio [2] (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 [3] 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 [3], and take a look at this piece about tracking difference [4].1 [5]

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. [6]

The Vanguard [7] 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:

Cons:

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 [10] against their benchmark returns on your favourite chart comparison tool.

Compare tracking error with a charting tool [11]

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:

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 [15] 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. [ [20]]
  2. iShares FTSE 100 [ [21]]