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

For example:

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.

Look out!

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,

The Accumulator

Good reading around the web this weekend.

However many times you warn them about scams and tricksters, people don’t listen.

I’m not only talking about the likes of my mother, who is an old-fashioned sort who believes that if somebody has taken the time to knock on her front door or phone her up then she should speak to them – even if they’ve blatantly only come to check if she’s senile enough to be diddled out of her pension, or when they’re phoning from Nigeria.

Even less interested in scam stories, seemingly, are the likes of Consumer Direct, The Office of Fair Trading, the FSA, and the National Fraud Agency.

All these and more turned out to be completely uninterested when MSN Money journalist Neil Faulkner tried to shutdown a scam website promising guaranteed 100% gains over five years and 100% protection for your money (about as likely as me getting a gift-wrapped Keira Knightley for my birthday, and her having arranged the whole thing personally when she discovered my deep interest in nerdy financial matters).

The journalist discusses this official disinterest in my post of the week, from The Motley Fool:

You can’t go and say, look – I know that there could be people losing thousands here. There could be people losing millions altogether, so please can you investigate. They don’t do it. They only want to hear about it after you’ve lost the money. As you and I both know, when you lose money in these investment scams, you normally don’t get it back, so it doesn’t help anyone.

The complete interview, which recounts how a dozen scam-busting bodies and charities showed no interesting in busting a scam, is also available as a podcast.

It makes for enlightening – and depressing – reading. If these scammers were shoplifting or mugging grannies, they’d be nicked. On the Web, they rip-off their victims without a care.

It all proves again that only you can be responsible for your money:

• Delete anything that comes through email.
• Ignore junk mail and shred old documents.
• Hang up the phone at will.
• Go ex-directory where possible.
• Don’t buy any product or service you didn’t initiate the hunt for yourself.

When it comes to investing money, look out for FSA-registration and research widely. Most people should simply use common-as-muck tracker funds, anyway, so you’d better have a good reason to go off-piste.

Outlandish promises on a website do NOT qualify for ‘extremely good reason’ status. Trust me, I’d know if there was a safe way to get 100% gains over five years with no risk.

[continue reading…]

Like most others, the UK government borrows money by issuing bonds. In the UK, these government bonds are called gilts.

The name ‘gilts’ hints at their antiquity. Back in the day, gilts were pretty certificates with gold-leaf trimming. These certificates are the origin of the phrase gilt-edged security.

Today gilts are bought and sold electronically. Given that the cash-strapped British Government has been raising more than £200 billion a year by auctioning off new supplies of gilts, that development is perhaps to the relief of postmen across The City.

Back in 1997, the entire stock of outstanding gilts was a mere £275 billion! By October 2010 it had surpassed £1,000 billion.

Gilts are the safest form of UK investment

An investment in gilts has long been considered about as safe as investing gets. The British Government has never defaulted on its debts in its several hundred years of raising money. Only US Treasuries and the bonds of a few other countries are considered as secure.

This perceived security is reflected in the UK’s AAA-rating for its debt. The AAA-rating has so far survived even the sharp deterioration of the UK’s financial strength in the wake of the credit crisis and recession of 2008/09, as well as quantitative easing.

The UK Treasury (via the Debt Management Office, or DMO) has skilfully taken advantage of our excellent reputation by issuing gilts with a very long life. Gilts have been issued with as long as 50 years to run until they’re redeemed.

Investors will only buy such long-dated securities if they’re confident the government will still be honouring its debts in 50 years time!

The UK has its own currency, of course, which in principle makes paying its debts a formality – unlike you, me, or a company, the government can simply print money to meet its debt payments.

Investors in gilts aren’t idiots, though, and they’re well aware of this. The trust placed in gilts isn’t just that the UK government will honour its debts in full, but also that it will manage the public finances in such a way that high inflation won’t erode the value of their investment.

The average maturity of UK gilts is around 14 years. This is the main reason why we have so far avoided the sort of sovereign debt panics that struck Greece and Ireland. The markets can take a sanguine view, knowing we’ve years to come up with the money to pay out debts.

Gilts: The basics

If you buy a gilt when it’s issued for exactly its nominal value and hold it to its redemption date, you know exactly how much money you’ll get over the years.

• You’ll be paid the interest rate (the coupon) every year plus you’ll be repaid the nominal value of the gilt when it matures.

For instance, a gilt called Treasury 5 pc ’30 will pay £5 a year until 2030 for every £100 nominal (also called the face or par value) that you buy and hold.

Gilts are generally sold by the government for a little more or less than their nominal value, however.

• The price investors pay for new gilts is determined by an auction. This means they may pay more or less than the nominal value (say £101 or £99), which reflects the annual yield they’re demanding for holding the gilts.

• If investors pay more than the nominal value to own the gilt, they’re accepting a lower yield. And vice-versa.

• The coupon payment is split across two payments a year.

When the redemption date is reached, the government pays you back the nominal value of the gilt. This makes it almost impossible to lose money with gilts in cash terms, provided you hold until redemption and the government doesn’t default, though inflation can easily erode your real returns.

Note that this doesn’t mean you’ll necessarily get back what you paid for your gilts. You might pay £105 in the open market, and receive just £100 back when the gilt is redeemed. However this capital loss will have been taken into account by the market and reflected in the income you’ve received for holding the gilt. This total return is the key.

Some gilts are undated. For instance, there’s a nearly 100-year old gilt called War Loan 3 1/2 pc.

Undated gilts payout their coupon forever. They can be considered a bet on very long-term interest and inflation rates.

Gilts are traded, which introduces risk

Once issued by The Treasury, gilts can be bought and sold on the secondary market until they mature, just like shares and other securities.

An easy way to think of how their price fluctuates is to imagine what you’d pay to own the aforementioned War Loan 3 1/2 pc:

• What would you pay if interest rates on savings were 6%?

• What would you pay if interest rates on savings were 2%?

All things being equal, an investor would obviously pay more for a 3.5% coupon when interest rates on cash are lower than that, and substantially less when interest rates on cash are higher.

The investor’s calculation is complicated by the fact that an undated gilt is never redeemed. This means his view of interest rates (and inflation, and UK solvency) must extend far into the future.

Dated gilts are less risky investments. You know you’re going to get the nominal value back (not the price you paid, remember!) when they are redeemed, regardless of how their price fluctuates in-between. This makes it possible to calculate a yield to redemption, which takes into account both the annual coupon you’ll be paid for owning the gilt, and the capital gain or loss you’ll make when the gilt is redeemed.

This assumes you hold the gilt until it’s redeemed, of course. If you sell it before then, you might make a trading gain or loss.

You don’t have to calculate redemption yields and so on for yourself. Prices and yields are listed in newspapers like the Financial Times, and on websites like Fixed Income Investor.

A few other useful things to know about gilts

• The interest payment from gilts is treated as taxable income.

• Any capital gains that arise from disposing of gilts are tax-free.

• You can buy gilts directly through your broker or invest via a fund.

• Gilts can go in an ISA provided you buy them with five years until redemption.

• Index-linked gilts are a special kind that offer inflation-proofing. Both the coupon and the principal payment are adjusted in line with RPI. You might not get much on top of that though, depending on the mood of investors when you buy.

Further reading on bonds

I have written extensively about bond pricing and yields on Monevator in the context of corporate bonds. Gilts are priced and traded in exactly the same way, only the risk of default is far lower.

Here’s some articles to help you understand more about bonds:

• How to calculate bond yields
• What causes bond prices to fluctuate?
• Where to find bond prices and yields
• Government bonds and asset allocation

For yet more information on gilts, check out the DMO’s official lowdown on gilts.