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Tracking error: A hidden cost of passive investing

Tracking error is often cited as a key factor in tracker fund selection. Tracking error is to tracker funds as goal tally is to a Premiership striker – a fundamental measure of how well the job is being done.

A tracker’s role is to deliver the returns of its benchmark index. In an ideal world, if the FTSE All-Share index returns 10% a year, then a FTSE All-Share tracker will also return 10%. But the world is rarely perfect (mine isn’t anyway), and tracking error shows just how wide of the (bench) mark the performance is.

That’s important information for passive investors because it can reveal the hidden cost of owning a tracker. There’s no point choosing a fund with a Total Expense Ratio (TER) 0.2% cheaper than its rivals, if its returns consistently lag the same benchmark by an extra 0.5%.

What exactly is tracking error?

Like so many investing terms, there are many different versions of tracking error and ways of calculating it. It’s therefore often difficult to be sure that two different sources are talking about the same measure.

That said, a reasonably common definition of tracking error is:

Tracking error = the standard deviation of returns relative to the returns of the index.

Tracking error = the standard deviation of returns from the index

The lower the tracking error, the more faithfully the fund is matching its index.

When comparing funds, choose the lowest tracking error possible. A tracking error above 2% indicates the fund is doing a bad job.

What causes tracking error?

An index tracker is like an impressionist. It mimics its benchmark but can never quite be a dead ringer, chiefly because of:

  • Costs

Index returns aren’t dragged down by operating expenses, but tracker fund returns are. Therefore you’d always expect a fund to lag its benchmark by at least its TER. The TER is deducted from the fund’s net asset value (NAV) on a daily basis, so the lower the TER, the lower the tracking error, and the better the expected fund return, all things being equal.

  • Replication

Full replication funds that hold every stock in their index should offer zero tracking error as they are the index. (Except that transactions costs incurred when rebalancing ruin the beautiful dream).

Partial replication funds that sample a portion of their benchmark’s securities (because the cost of holding them all is too high) will inevitably generate tracking error, being only a representation of the index rather than a perfect clone.

Synthetic funds use swap-based contracts to guarantee they match their indices’ performance. But the swap fees and collateral costs incurred by the contracts drag down fund performance against the benchmark.

Taxes and transaction costs like brokerage fees and trading spreads add to our tracking error woes, no matter which replication model is used.

  • Turnover

The more trades a fund makes, the greater the trading costs, which ultimately undermines performance and adds to tracking error.

  • Management experience

Although index funds are popularly thought to be so simple that they can be run by VIC-20 computers, better management can rein in tracking error. Look for funds with a long record of tight tracking error.

  • Enhancements

This one actually works in our favour. Funds can earn extra revenue that closes the performance gap (or even turns it positive). Typically this income comes from two sources:

  1. Fees earned by lending out fund securities to short-sellers.
  2. Dividend enhancement – lending out securities to tax-benign territories when dividends pay out.

Now what?

So that’s tracking error in a blog-style nutshell. And everything would be hunky dory if fund providers published tracking error on their factsheets just like TER. But they don’t, and there’s no regulatory requirement for them to do so.

Clean comparisons of funds by tracking error are nigh on impossible in the real world. You might work tracking error out for yourself, if you love equations, but that doesn’t sound like many couch-potato investors I know.

Instead, you can use tracking difference as a substitute for tracking error when you want to compare rival funds.

Take it steady,

The Accumulator

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Weekend reading: House price affordability

Weekend reading

This week’s best post from elsewhere, plus more good links from around the Web.

Anyone who read my post on house prices predictions may have sensed my enduring frustration with the London property market.

If you thought cockroaches were hard to kill, you should try stamping out house price inflation in desirable streets in Zone 2.

London prices will always be high, absent a dirty bomb. The question is are they justifiably tear-jerkingly elevated, or are they pricey even for loaded Londoners?

To investigate, I was all set to produce some pretty graphs as a follow-up. But then I noticed The Finance Blog has sprung back into life and done it for me.

I’m all about the 80/20 rule of time management, so my Post of the Week comes from the Finance blog!

Here’s its crunching of the current house-price to earnings ratio:

The bounce before the bottom?

Perhaps its wishful thinking, but to me the London ratio looks like a trend reverting to mean, interrupted by emergency interest rates in March 2009.

Alternatively, perhaps the recovery in equity markets resurrected London house prices by reflating bankers’ bonuses? I say that because the North has only flat-lined, despite the deluge of cheap money (for those who can access it).

The Finance blog also has useful graphs on affordability, and on the percentage of FTB pay that goes on a mortgage. Property addicts should go check it out.

[continue reading…]

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House price predictions 2011

House prices over the year

I thought I’d round up a bunch of house price predictions for 2011, like I did last year.

Well, obviously last year the predictions were for 2010, not 2011. They ranged from the bearish -10% of Capital Economics to broker John Charcol’s indecisive and unfeasibly bullish 4-9% rise.

As it turned out, UK house prices fell 1.6% over 2010, according to the Halifax House Price index.

The decline left the ‘average’ UK house 18.5% cheaper at £162,435, compared to £199,766 at the 2007 peak. Quite a drop – and those are in nominal terms, too. Adjusting for inflation, the real decline will be more like 25%.1.

The entirely honorary prize for the most accurate prediction for 2010 goes to upscale estate agents Savills, which predicted a 3% decline, easily beating the rest. Who said you couldn’t trust an estate agent?

Down your way?

Of course, you don’t need me to tell you that the ‘average’ UK house is a phantasm at the end of a cul-de-sac off the Watford Gap, and that local prices are all over the place.

Conwy in Wales, for instance, saw prices rise by 13% in 2010. In Aberdeenshire prices remain 46% ahead over five years, compared to just 1% higher for the UK as a whole.

The Halifax figures are less reliable than they once were, too, due to the mortgage drought. Here in London, many expensive homes are now purchased mortgage-free, and for the past 18 months they’ve been largely bought by upscale overseas buyers flush with a valuable currency.

That’s pushed prices in the top postcodes to all-time highs. But due to it only recording properties bought with its mortgages, you won’t find this recorded in Halifax’s index, which still has London prices well down on 2007.

Nevertheless, I like to follow the Halifax index because it’s the longest running data set. The trends all tend to converge over time, anyway.

House prices in 2011

Without further ado, here’s what the pundits predict for 2011:

Prediction Source
Jonathan Davis (HousePriceCrash.co.uk) -10% BBC News
Capital Economics -10% BBC News
Halifax -7% The Guardian
Savills -3% Savills PR
Hometrack -2% The Telegraph
Royal Institute of Chartered Surveyors -2% BBC News
Centre for Economics and Business Research 0% Daily Mail
Nationwide 0% This is Money
John Charcol (Broker) 2% BBC News

All predictions are for movement in the UK average national house price. The ‘source’ column links to where the prediction was cited. No predictions are more than a month old.

In some cases, these are summaries of more nuanced views – or more dubiously specific ones, depending on your perspective.

The Council of Mortgage Lenders, for example, offers a very detailed rationale for its forecast, which I couldn’t really summarize. Then again, its members aren’t doing much lending, so I guess it has a lot of time on its hands!

I feel prices should be going lower, but I have to be wary of my London bias. Truth is I am surprised to see prices down so much across the rest of the country. Affordability has improved in the provinces, too.

Another 10% off and I’d start wondering if it was time to load up on housebuilding shares. As I’ve written several times, I don’t think the spending cuts will be half as painful for working people as is popularly supposed, and my prediction last year that Britain had recovered is now evident on the ground.

Interest rates are still low, too, and given the way they look set to hand out big bonuses, the banks may have the money to increase the flow of mortgages.

On the other hand, my prediction of a 5% advance in prices in 2010 was well off the mark, especially as while I predicted any surprise would be to the downside, I said it would be probably be due to a shock interest rate rise. Oops!

Also, property still looks expensive by several measures. I’ll recap these ways of trying to value houses in a future post, so please do subscribe.

Where do you think UK house prices will end the year? Tell us below, with a link if it’s not your prediction. Maybe I’ll give a prize if we’re all here in 2011!

  1. Sorry, it’s late and I haven’t worked out the accurate deflated figure. 25% is a guess! []
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The UK small cap ETF that’s too big for its boots

I was one happy passive investor when Credit Suisse launched their UK small cap ETF (ticker CUKS) on the London Stock Exchange last September.

It was the first UK small cap tracker: plugging a gap in the market that denied passive investors an important route to diversification, and the potential of enhanced returns. Or so it seemed.

Sadly, now I’ve looked into CUKS, it’s not my idea of what a UK small cap ETF should be. It’s actually closer to a pricey mid cap tracker, in my opinion.

It’s the law

One of the unbreakable rules of tracker-buying is to always check the index; making sure the fund you’re eyeballing adds the exposure your portfolio needs.

In the strange case of CUKS, the benchmark is the MSCI UK Small Cap index. But what’s actually in this?

It’s worth exploring, because there’s no commonly agreed size limit for a small cap company. You can end up with some fairly big beasts falling into your ‘small cap’ index, especially if your net’s mesh isn’t very fine.

And rival UK small cap indices have very different ideas about how close to the bottom of the market they’ll go when trawling for small caps:

  • The FTSE SmallCap Index captures roughly 2% of companies in the 98th and 99th percentiles of the UK market.
  • The RBS Hoare Govett Smaller Companies Index captures roughly the bottom 10% of the UK market.
  • The MSCI UK Small Cap Index captures roughly the bottom 14% of the UK market up to the 99th percentile.

The upshot is the MSCI index is doing a lot of fishing in the FTSE 250 layer of the market. What it defines as small cap, many UK investors think of as mid cap. And that could mean some major overlap if you’re already holding FTSE 250 funds.

CUKS mostly fishes for firms in the depths of the mid cap FTSE 250

What’s more, CUKS has a TER of 0.58% – more than double the 0.27% TER of HSBC’s mid cap FTSE 250 index fund (which can be bought sans trading fees).

So the key question is: how much small cap coverage am I getting from CUKS that I can’t get from a FTSE 250 tracker?

In my opinion, not enough.

X-Ray vision

Morningstar’s Instant X-Ray tool enables you to probe funds for overlap.

I compared CUKS with HSBC’s FTSE 250 index fund. Tellingly, Morningstar classifies both funds as mid cap. The detailed analysis of stocks held in the funds also revealed the following market cap breakdown:

Large cap Mid cap Small cap
CUKS TER 0.58% 0.92% 57.29% 41.79%
HSBC FTSE 250 TER 0.27% 4.9% 56.50% 38.59%

Morningstar Instant X-Ray analysis, January 8, 2011.

According to those stats, buying CUKS would gain me only a few extra percentage points of small cap stocks in my portfolio over a regular FTSE 250 index fund.

Yet I’d be paying more than double the TER plus trading fees for the privilege.

You can check the constituents of CUKS on Credit Suisse’s website. Go to Products > Equity > UK > CS ETF (IE) on MSCI UK Small Cap > Portfolio Structure. Most holdings are FTSE 250 firms. Fewer than a quarter are from the FTSE SmallCap or FTSE AIM All-Share, at the time of writing.

It looks like a poor deal in my book. I am prepared to pay a higher TER for a fund that tracks an index like the FTSE SmallCap. But I’m not paying well over the odds for a mid cap ETF with a small cap accent!

Take it steady,

The Accumulator

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