When it comes to choosing an index tracker, the great Tim Hale [1]
Tracking error (or tracking difference [3]) is the best measure of the true cost of your index tracker. It reveals by how much the returns of your fund have deviated from the index it’s supposed to match.
In other words, tracking error shows you the impact of all fund costs, including the charges that don’t show up in the Total Expense Ratio [4](TER).
[5]
To demonstrate how big a dent those hidden costs can make in your returns, I’ve compared the tracking error of three of the cheapest FTSE All-Share index funds.
Cheap FTSE All-Share trackers compared by TER
First, let’s compare [6] our index funds by TER – the simplest match-up criteria for lookey-likey trackers.
| Index Fund | TER |
| Fidelity Moneybuilder UK Index Fund | 0.3% |
| HSBC FTSE All-Share Index Fund | 0.27% |
| Vanguard FTSE U.K. Equity Index Fund* | 0.15% |
* The Vanguard fund also levies a 0.5% initial fee for stamp duty.
The Vanguard [7]fund is the cheapest of the three by TER (even with its initial fee on new contributions it will beat HSBC after 9 years). But the difference between the funds is nothing to lose sleep over.
If you stuck £300 a month away for the next 20 years then your Vanguard pot would be 1.2% bigger than a Fidelity pot.
You’d be about one and a half grand richer by the end. Woot!
Let’s see what happens when we bring tracking error into play.
Cheap FTSE All-Share trackers compared by tracking error
| Index / Index Fund | Return | Tracking error | TER |
| FTSE All-Share index | 0.7% | – | – |
| Fidelity Moneybuilder UK Index Fund | -0.12% | 0.82% | 0.3% |
| HSBC FTSE All-Share Index Fund | 0.2% | 0.5% | 0.27% |
| Vanguard FTSE U.K. Equity Index Fund | 0.63% | 0.07% | 0.15% |
Performance figures are for one year: 15/2/11 to 15/2/12.
The tracking error1 [8] is purely the difference in performance between a tracker and its index [9].
The lag in performance is generally caused by TER, transaction costs2 [10] and sampling error3 [11].
Those extra costs make all the difference:
- The Fidelity fund didn’t cost 0.3% in the last year but 0.82% – getting on for three times as much.
- The HSBC index fund cost nearly twice as much as its TER indicates.
- At 0.07%, the Vanguard fund cost less than half as much as its TER. Magic? See below.
The Vanguard fund is still the cheapest (it outstrips HSBC after 3 years at the above rates), the Fidelity fund is still the most expensive but the gap between them has widened significantly.
And now the gulf in class is worth worrying about.
Put £300 away in each fund for 20 years and your Vanguard pot would end up 8.2% bigger than the Fidelity one – assuming the tracking error stays constant.
A false economy
Bear in mind I’m not saying cut and run from your current index tracker on the basis of the above. There are a number of other factors to take into account (as ever) and I’ve covered these in a follow-up post [12].
Also I must warn you that I plotted the self-same comparison via Hargreaves Lansdown and Google Finance and got completely contrary results. The performance data above comes from Hargreaves Lansdown but, when I checked on Google Finance, the result reversed – Fidelity won and Vanguard lost.
Hard though it is to diss the data-masters, I have strong reason to believe that the info on Google Finance is wide of the mark – specifically because it disagrees with Fidelity’s own published results (which tally precisely with the Hargreaves Lansdown data).
Hargreaves Lansdown takes its data from Financial Express, which is the same outfit that runs Trustnet.
Still, even though it’s harder to get a straight answer in the investment world than from a politician’s expense claim form, I’d urge all passive investors [13] to investigate the tracking error of their funds, where possible.
We get caught out all the time as consumers by failing to account for the full cost of things. We buy big houses without regard for the big maintenance bills, dream cars without thinking about their insatiable demand for fuel, and cut-price printers that need their cartridges changed more often than a baby’s nappy.
The same is true for index trackers, so don’t stop at TER – use tracking error to nail the true cost of a fund.
Take it steady,
The Accumulator