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,