Knowing how closely your tracker hugs its benchmark index should be at the top of every passive investor’s To Do list.
Your chosen fund may have a dirt cheap Total Expense Ratio (TER), but if it lags its index by 2% a year then you’re paying a lot more for it than you realise.
No tracker perfectly delivers its benchmark’s returns. Tracking error is the measure that’s commonly used to describe and compare this deviant behaviour.
Yet the investment gods are cruel, and currently you’ll be hard-pressed to find many fund providers or independent investment sites queuing up to offer you tracking error data that can be meaningfully compared across all funds.
Try tracking difference
So when you’re choosing between trackers, you’re better off using a simpler measure that’s easier to find and use. Some call it tracking deviation, some call it trailing returns, and yet others call it tracking difference.
What we do know is that it’s a simple comparison of:
Total fund return Vs. total benchmark index return
If the Global Llama Volatility ETF (LAME) returns = 1%
And, its benchmark Llama Vol index returns = 2%
Then tracking difference = 1%
Whatever the TER says, that tracking difference provides a far more accurate description of the cost of owning that fund.
Check the tracking difference over:
- 1 year (minimum)
- 3 years (better)
- 5 years+ (you’ll be lucky)
- A cumulative basis
Given the explosion of new trackers launched in this country over the past couple of years, it’s a struggle to find even three years of data to rub together for the average fund, so consider my wishlist as more of a forward-looking statement.
There are plenty of pitfalls to trap the unwary investor seeking a simple tracking difference reading:
- Make sure you’re checking like with like. The comparison is only meaningful if you’re pitting the tracker’s performance versus the actual index it tracks. You’ll find that information on a fund’s factsheet.
- Data from Morningstar or Trustnet can be used but should be treated with caution as they regularly use the wrong index to benchmark a fund. Even a fund as straightforward as HSBC’s FTSE All-Share index fund is compared against the FTSE 100 by Morningstar.
- You can chart your tracker against one of the more common indexes on Google Finance, Trustnet, or Yahoo Finance, but if the benchmark index is more unusual then these sites won’t enable you to dial up the right data.
- Beware there can be a few different versions of the same index. Check whether your fund is meant to hug the Total Return version, or the Price Return incarnation.
So where do I turn?
The best source I’ve found to make tracking difference comparisons are the fund factsheets. They generally show the last 1-3 years performance against the correct index (assuming the fund’s been around that long), as well as cumulative performance.
Watch out for product providers who present this information before management fees. Comparing a tracker’s return against its index before subtracting a dirty great TER gives a misleading impression of how well the fund is doing and, more importantly, how well it will really do for you.
When comparing similar funds:
Choose the fund with the lowest tracking difference over as long a time period as possible.
The larger the performance gap between fund and index, the more flawed the product is. Even a tracker that’s trouncing its index is no cause for celebration. Trackers are designed to match the market, not beat it, so deviant performance simply shows the product isn’t to be relied upon over the long-term.
Chances are that the funds with the lowest TERs will also be the ones with the lowest tracking difference. But if you face a choice between a fund with a low TER and one that’s cheaper after tracking difference, then I’d plump for the latter.
Take it steady,
Great post. Here is a kindergarten question from a novice. Can the fund factsheets be obtained from their websites or do we have to request for them?
@Alan iii seems to offer good fund factsheets, such as (http://www.iii.co.uk/factsheets/?type=detail&mex=MDFTA). They’re what I’ve been using anyway!
With regards to the article, (another kindergarten question) given the TER, Total fund return and total benchmark index return, how would you calulate a figure that you would compare with other similar trackers?
1. Given the paucity of data and lack of effective scrutiny, is there any incentive for an index fund manager to minimise tracking difference?
2. It seems to me that an index fund manager is not held to account for its tracking difference – unlike TER.
3. An idea: index fund managers could compete on tracking difference to the benefit of the consumer…
@TA – I must say I’ve noticed this too, for instance most of the HSBC tracker funds are just about on-target, whereas most of the Vanguard trackers seem to beat the index by a slight but noticeable amount.
It made me think about your previous article about Vanguard funds with regards to the higher upfront costs due to the expensive platforms and upfront fees. It would be interesting to figure out what an equivalent investment over a 5 or 8 year period would have been with consideration of the additional performance, and whether this would ever offset the high platform fees etc.
@ Alan – You can get the factsheets on the product providers’ websites. Click on the fund and there will normally be a ‘documents’ section where you can download the pdfs. Brokers and independent sites like Trustnet will have them too. I tend to use the product providers though, to ensure I’m looking at the latest version.
@ Jonny – just compare the fund return to the index return. The impact of TER will show in this difference along with all the other intrinsic costs.
@ Alex, I agree entirely, tracking difference would be a better measure to use than TER. I guess the difficulty is, from a regulatory point-of-view, that no-one can guarantee next year’s tracking difference, whereas they can set the TER in stone.
@ Marc – this is relatively easy to do using a fund cost comparison calculator: http://candidmoney.com/intro/calculators.aspx
Scroll down to investment calculators to find it. Sorry, there isn’t a direct link.
Put trading fees in as the initial charge and put tracking difference in as the annual charge. Again, there’s no guarantee that current tracking differences will persist, but then there’s no guarantee about anything, I suppose.
Have you noticed on the HSBC pacific index tracker ( which i use myself ) , when you compare the charts to the global emerging markets funds , they are virtually identical , apart from the costs of those emerg mkt funds being 5 times higher , so not sure if there is much diversification in trying to be globally invested
The L & G pacific tracker just pips the HSBC one , even though the charges are over double , but with Hargreaves Lansdown adding on a further 0.5 % charge that probably evens things out
Now Vanguards on the scene .. would be nice to see these TER’s reach 0.1 at some point
Trying to beat mr market is futile i admit , i have been humbled by mr market ! .. so now i accept mr markets average return 🙂
Keep up the good work ~ THE ACCUMULATOR
1. Hi TA, thanks for the response.
2. Before my original comment, I’d been thinking about the issue you raise: the inherent unpredictability of tracking difference.
3. Would it not be possible for an index fund manager to guarantee its tracking difference? That way, the consumer could safely buy the fund knowing what the outcome would be, given the performance of the relevant index. This would obviously be very helpful for the consumer – and allow the competition I mentioned.
4. Granted, the index fund manager would have to do a bit more work to ensure the specified returns. I don’t think that would be too difficult – I can think of several ways to do it. One potential problem would be: the extra risk involved in the operation of the fund – but this could and should be mitigated. Another is: the lack of transparency for the consumer. However, I don’t think the latter is as compelling as it should be: we’ve already seen how difficult it is to obtain meaningful tracking differences. For the consumer, index funds are already not as clear as they should be.
@ Davyjones – not sure what you mean. The HSBC Pacific index fund is 30% in Australia, 20% in South Korea and so on with a negligible amount in China. Nothing in Brazil, Russia or India. It’s not a proxy for an emerging markets fund.
@ Alex – I imagine guaranteeing tracking difference would entail considerable financial risk for a fund manager. If they ran a physically replicating fund they’d have to be able to forecast new entries and exists from the index. You’d think it would be more doable with a synthetic tracker, where the income is guaranteed, but I’m no expert on the terms and conditions of swap contracts. If it’s difficult to do and add costs then that cost would get passed on to investors. Nonetheless, I agree with your points on transparency, and I think the real costs of investing in all funds should be made explicit, comparable and in plain English.
We know trackers are doing clever stuff to try and reduce the gap: It doesn’t happen carelessly! The only way they’d be able to guarantee a max error I suspect is basically by paying cash to reduce the error (perhaps by taking out insurance, which would be a fixed cost…) Ultimately someone has to pay for dirt cheapness, and perhaps it’s the investor whose tracker deviates too much one year. Just make sure it’s not yours every year!
…although if some over deliver and some under deliver the index return, perhaps they’d net off, provided they are legally allowed to move the surplus funds to the deficit. (They’re probably not, for good reason).
How do you make a holistic approach to choosing the right tracker as there seem to be other variables in the mix?
HSBC FTSE ALL Share Index Charges
0.10% annual charge
0.17% ongoing charges
0.05% registration fee
0.16% tracking error (3 year annualised as at 31st May 2013)
Vanguard FTSE UK Share ALL
0.50% Levy on subscription (how exactly does the levy work?)
tracking error (unless i’m reading the factsheet wrong – i’m a novice to personal investment – it looks as though Vanguard are 100% on target?)
In this case then the Vanguard Index trumps HSBC’s (0.32%), correct?