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 error ¹ is purely the difference in performance between a tracker and its index.

The lag in performance is generally caused by TER, transaction costs ² and sampling error ³.

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

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

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…]

Sensible investors put their money to work across the world, rather than only investing it at home.

Buy British or Made in USA are good slogans for the sellers of knitwear, tractors, and cauliflowers, but they’re a poor guide if you want to build a robust portfolio.

This isn’t because I expect the British stock market to whither away like our coal mining or ship building industries did, or because the troubled UK economy is doomed.

On the contrary, I think the London Stock Exchange is one of the world’s most attractive, with companies that offer an appealing mix of growth, income, stability, and innovation.

As for the UK economy, reports of its death are much exaggerated.

Besides, the biggest UK companies that dominate the FTSE All-Share index do over 75% of their business overseas. This means they’re far less dependent on the performance of Blighty PLC than is popularly supposed.

But our companies are more exposed to certain regions of the world than others.

It’s been said, for example, that we export more to Ireland than we do to the BRIC ¹ nations combined, which is a tad worrying given how it sometimes seems there are more Irish backpackers in Irish bars across the world than there are Irish citizens in Ireland!

More generally, UK trade is dominated by business done with mainland Europe.

But trade is a global affair nowadays.

Investing overseas therefore gives you access to different types of companies and opportunities, unconstrained by history or the geographic accident of our lump of rock’s position on the spinning globe.

Gambling with your country’s money

Investing in foreign shares exposes you to currency risk, which is to say your overseas investments will change in value as their price in the local currency fluctuates when converted back into pound sterling.

In the short-term this can be a good or bad thing, in terms of your profit – it depends how exchange rates go after you make your overseas investment.

Over the long-term, however, currency variations on average play a minor role in total equity returns. Currency hedging is expensive and difficult for private investors, so I wouldn’t worry too much about it provided you’ve got a long time horizon and you’re spreading your equity buying across the world.

Oh, and in case you’re wondering if overseas investing means you’ll need to phone city boys in Shanghai or Sydney to place trades, fear not!

While you can hold even individual foreign company shares in an ISA, the majority of us are best off using collective funds for the money we invest away from our home country.

(Most of us are best off in UK trackers, too, for that matter, but that’s a different dozen or so articles).

Investing overseas via funds could entail you buying index trackers that follow foreign markets, like those we use in our Slow & Steady model portfolio. You can even track emerging markets using passive funds.

Alternatively, new country-specific ETFs are debuting all the time, though most investors will find it simpler and safer to aim for broader regional exposure.

Some investors like myself also put money into big global investment trusts like RIT Capital Partners. This trust invests very widely around the world, and its managers actively monitor currency exposure as an added benefit (or not, as it may turn out) for its shareholders.

Investing globally is more helpful with shares than bonds

The main benefit of investing overseas is that diversification across countries can be expected to reduce risk in your portfolio, without doing too much damage to your overall return.

According to the latest research from the very credible London Business School ², the risk reduction you’d have seen from holding the world index rather than owning only domestic equities between 1972 and 2011 made diversification worthwhile for every major country studied except South Africa.

They found that investors in the core 19 countries looked at ³ would have enjoyed a risk reduction of on average 20% from holding the world index, as opposed to if they’d held only their own countries’ shares.

Academically speaking, that’s a trade-off you should take, even if it slightly reduces your return (though see below for more comments on risk).

Investors from Norway and Finland would have seen around a 50% reduction in risk, due to how skewed their economies are, and the overweight presence of a few massively larger companies. Take note, if you’re Norwegian or Finnish!

Interestingly, the professors do not report the same risk-reducing benefits from diversifying into global bonds.

With bonds, the currency risk outweighs the benefits of diversification.

This is probably because in general, a creditworthy government bond is a creditworthy government bond – it pays you a fixed rate of interest and you (hopefully) get your money back when the bond matures.

Hence currency risk looms large with bonds, compared to the minor diversification benefits of holding one developed country’s bond versus another, given that most mature developed world sovereigns have not defaulted in the past few decades. (Some might suggest the professors stand ready to re-write their rule books.)

In contrast to bonds, by buying foreign shares, you are getting access to different country’s industries, trading partners, local specialisms and resources, as well as varied politics and demographics.

That’s real diversification!

The risks of picking the best countries to invest in

Some foreign share markets will likely do a lot better than others in our lifetime, of course.

This means spreading money across the world’s stock markets will likely reduce your returns, compared to if you bought only the best performing markets.

But before you put on your red braces and go winner-spotting, keep in mind:

• Picking winners on the basis of, say, historically faster-growing GDP is a losing strategy.

• Investing in fewer overseas markets will lower the risk-reducing benefits you’ll enjoy, compared to investing in the global index.

• Most people are likely to be as bad at picking winning markets as they are at picking winning stocks, so they will lose to a global tracker (or else they’ll simply pay for any higher returns by taking more risk – see below).

• If a market grows faster or looks cheaper, it may be for a good reason (likely because it will be more risky and/or volatile).

• You’re more likely to stomach the most volatile but potentially highest reward markets – e.g. Brazil or Russia – if their gyrations are offset by steadier holdings elsewhere in your portfolio.

Remember, risk isn’t necessarily something to be entirely shunned. I haven’t got a problem with a young investor putting a bigger allocation into a spread of emerging markets, say, for the prospect of higher long-term returns, provided they’ve understood the extra volatility that’s likely along the way.

But I would still argue against betting very heavily on any particular country, or even region, in the pursuit of extra riches.

Few of us really want to gamble away a happy retirement for the prospect of a few more bottles of champagne in our old age.

Accordingly, most of us should sacrifice a few tenths of a percent of return by spreading our money more widely in order to sleep better at night. It’s the same rationale as that for having a diversified portfolio that includes bonds and other low return, low volatility asset classes.

As we’ll see in my next post, you don’t want to try to pick the United States of the 21st Century, only to discover you actually invested in the equivalent of the Greeks.

1. Brazil, Russia, India and China.[↩]
2. The Credit Suisse Global Investment Returns Yearbook 2012, to be exact.[↩]
3. Basically all the biggies where they have data stretching back to 1900.[↩]