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

by The Accumulator on February 28, 2012

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:

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

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

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Weekend reading: Buffett’s new shareholder letter

by The Investor on February 25, 2012

Good reading from around the Web.

With apologies to the authors below, there is only one must-read this weekend, and that’s Warren Buffett’s annual letter to shareholders.

Unfortunately I can’t yet link to it directly. The letter goes live today, Saturday, at 8am EST, which is 2pm in the UK. That’s after the posting time of this article and its associated email.

And I’ll be at least a pint into the Six Nations rugby by then!

To grab the PDF for yourselves after 8am EST / 2pm GMT, head to the Berkshire Shareholder Letter archive. This year’s letter will be marked ‘2011’.

[continue reading…]

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How to use tracking error to uncover the true cost of an index tracker

by The Accumulator on February 21, 2012

When it comes to choosing an index tracker, the great Tim Hale said: “Tracking error is your critical selection criteria.”

Tracking error (or tracking difference) 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 (TER).

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 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 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 is purely the difference in performance between a tracker and its index.

The lag in performance is generally caused by TER, transaction costs2 and sampling error3.

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.

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 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

Technically a returns comparison like this shows tracking difference – but everyone calls it tracking error in reality. [↩]
Buy/sell expenses. [↩]
Tracker holdings will usually deviate slightly from the index causing returns to differ. [↩]

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Weekend reading: Iceland comes in from the cold

by The Investor on February 18, 2012

My pick of the week’s money and investing articles.

A barely reported bit of news yesterday from the Fitch ratings agency should make pleasant reading in the parts of Europe that animal spirits can’t currently reach:

Fitch says Iceland’s long-term debt is now safe to buy, adding the outlook for the tiny North Altantic nation is stable.

Fitch upgraded Iceland’s debt to BBB- from BB+, lifting it out of junk status. Fitch cited the slow but steady progress made by Iceland in emerging from its 2008 banking and currency crisis.

Iceland’s debt-laden economy was the first to crumple under the weight of the credit crunch, but has since begun to recover.

I’m not going to rehash the arguments over how Iceland got into its predicament again, nor wax lyrical about the similarities and differences with Italy or Spain, or Greece for that matter.

The short answer is Iceland has control of its own currency, a small population, rich resources, and a tradition of turning to government – and its own people – to reinvent itself out of a hole.

Other countries have different advantages, and problems, too. The important point is that doom-laden headlines such as those written about Iceland at the height of its banking crisis ought to be taken with a pinch of salt – and perhaps even treated as a cue to buy.

Particularly if they’re written by hysterical bloggers or the lunatic fringe of financial bulletin boards.

Most of the commentary about Italy, for example, has been truly dire. As I’ve written before, Italy is one of the richest countries in the world. It has pressing structural issues, sure, but it is only bankrupt in the sense that a man with a £1 million mortgage on 10 buy-to-let properties worth £5 million is bankrupt.

Which is to say – it isn’t.

[continue reading…]

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