The investing industry hides charges like FIFA execs hide bank accounts. Even relatively transparent vehicles like index trackers are not squeaky clean – the annual fee you see printed on the factsheet as the OCF or TER does not tell the whole story.
This is true for every fund, but at least for index trackers these extra costs are discharged like a telltale smoky belch that’s detectable using tracking difference.
Tracking difference shows you how far a tracker fund (that costs money) falls short of the performance of its index (that costs nothing).
For example, if the FTSE All-Share index returns 10% in a year and a particular index tracker only manages 9.5% then the tracking difference is 0.5%.
That 0.5% is the true cost of owning the fund, regardless of what the factsheet might claim.
How do I uncover tracking difference?
Until now, tracking difference has been a devil to calculate and compare across funds.
I’ve previously explored a bunch of ways. None of them has been the answer.
But now one of the investment data providers, Trustnet, has taken a very good stab at tracking difference in its new passive funds section.
Hit one of the asset class categories (e.g. UK equities) and you can compare the tracking difference performance of a decent range of index funds and ETFs. (Go to the performance tab.)
Here’s an example to show you the tracking difference, um, difference, between several funds.
First we use the tool to find the low OCF leaders:
FTSE All-Share top five trackers by OCF
| Index tracker | OCF (%) |
| Fidelity Index UK P | 0.06 |
| HSBC FTSE All Share Index C Acc | 0.07 |
| Vanguard FTSE UK All Share Index | 0.08 |
| L&G UK Index I | 0.1 |
| Royal London UK All Share Tracker Z | 0.15 |
Press the [+] button to reveal more fund versions on Trustnet’s site.
Now let’s see what happens to the line-up when we rank by tracking difference:
FTSE All-Share top five trackers by 3-year tracking difference (TD)
| Index tracker | 3-year TD | TD average p.a. |
| L&G UK Index I | 0.15 | 0.o5 |
| Vanguard FTSE UK All Share Index | -0.28 | -0.09 |
| HSBC FTSE All Share Index C Acc | -0.32 | -0.11 |
| Lyxor FTSE All Share GBP ETF | -0.47 | -0.16 |
| Old Mutual UK Index A Acc | – 0.61 | -0.2 |
Positive figure shows fund beat the index.
Holding tracker funds up to the righteous light of tracking difference substantially alters the top five line-up. Every position in the ranking changes. And two of the funds have changed – previous table-topper Fidelity Index UK P drops out of the rankings altogether, when ranked by tracking difference.
The Fidelity fund’s three-year tracking difference (not listed above) of 0.7% amounts to a true cost per year of 0.23%.
That’s nearly 400% bigger than the advertised fee of 0.06% (which you can only get if you invest in the fund by tying yourself into Fidelity’s platform).
In contrast the Vanguard fund’s tracking difference reveals a real cost per year of 0.09%, which is as near as dammit to the quoted OCF of 0.08%.
Vanguard’s initial charge – levied every time you invest, and put towards stamp duty – is probably the reason why it is able to sail so close to the coast.
HSBC’s All-Share fund does not impose an initial charge but there’s no avoiding stamp duty. This means investors cop it through lower net returns that are illuminated by the tracking difference score.
Most eye-catching of all is L&G Index I, which actually beat the return of the index by 0.05% per year and effectively paid you for owning it. Very nice of them.
However L&G isn’t providing its services for free, so how did it do it and can it keep it up?
Cost begone
There are various techniques for enhancing performance – the major one being securities lending.
In this scenario, a fund manager lends out individual securities (e.g. shares) to short-sellers in exchange for a fee.
The risk is the short-seller’s dark arts blow up in their face, they go bust and your security doesn’t come back.
Imagine Hertz rents out your car to someone in town for the day and it splits the fee with you – only for your car to accidentally get totaled in a Destruction Derby and to come back to you in a bucket.
I’m exaggerating for effect, of course, but securities lending is a risk and not every tracker provider does it.
So if you’re attracted to a fund because it’s outperformed its benchmark, it’s worth checking the provider’s securities lending policy and deciding if you’re comfortable with that.
Another reason why L&G may have outperformed is because it samples the FTSE All-Share to create its fund – it doesn’t fully replicate it.
In other words, the L&G fund buys enough shares to do a passable impression of the index but it doesn’t match it firm for firm.
It could be that its particular selection just happened to have a gold run that won’t be repeated over the next few years.
Tracking difference can fluctuate over time and that’s why many commentators recommend plumping for a tracker that hugs its index tightly as evidence of good management practices – regardless of whether the difference is positive or negative.
On that basis, the L&G UK Index I fund still wins with a 0.15 performance versus Vanguard’s -0.28.
Lookout below
You will find some funds with incredible figures like Chariguard UK Equities‘ 7.77% three-year outperformance of the FTSE All-Share.
There’s usually a snag and with this fund it appears to be uninvestable on the platforms available to the likes of you and I. (Anything this deviant is also no tracker.)
Meanwhile, the SSgA UK Equity Tracker has a positive 0.35% tracking difference, but I can only find this fund on Youinvest where it seemingly comes with a murderous 10% initial charge.
Another tip – don’t pay any attention to one-year tracking difference figures.
Results over short periods can be royally skewed by something as basic as the date the fund was measured, so use the longer term figure. Hopefully Trustnet will expand the service to a five-year view, too.
When making your comparison, be sure you are comparing like with like when it comes to the indexes (Trustnet refers to them as benchmarks).
For example, FTSE All-Share funds are very different beasts to FTSE 250 funds. Filter to ensure your comparison is relevant.
In contrast there’s little meaningful difference between the FTSE Emerging Markets and MSCI Emerging Markets indices. You can safely take your pick from trackers that play for either team.
You can find out more about an index by Googling it or by comparing funds using the Funds Library fund comparison tool and spotting the difference between holdings.
Be your own kingmaker
Trustnet has also thrown in a classic one to five stars rating system (except the stars look like crowns).
Rating systems are time-saving catnip but personally I think it’s important to develop a decent understanding of what an investment can do for you.
Trustnet’s methodology includes a weighting to tracking error and fund size, which I believe are much less important to buy and hold investors.
Personally, I’d rather be guided by tracking difference and a review of the most important features of the factsheet. It needn’t take long if you have a good underlying grasp of what you’re looking for.
A big difference
The main improvement I’d like to see from the tool is a global tracker section but hopefully that will come. In the meantime, here’s a few tips on divining tracking difference yourself.1
Quibbles aside, by creating a simple tracking difference reference tool, I think Trustnet has done passive investors a great service that will help us in our mission to crush costs and to navigate the investing hall of smoke and mirrors.
Take it steady,
The Accumulator
- Note, this article refers to tracking error rather than tracking difference. The terms are often used interchangeably but this article is referring to tracking difference as Trustnet means it. [↩]
Comments on this entry are closed.
I am not sure I would be relying on tracking difference more than OCF
In my understanding:
OCF = most but not all costs of running a fund
Tracking difference = OCF + securities lending profits to share/unit holders – costs not included in OCF +/- difference in composition between actual portfolio and index
In any three year period it could well be the difference between the fund and index constituents that make up the biggest non-cost element of the tracking difference. A difference between the portfolio and the index it is notionally tracking will result in a negative difference just as often as a positive one
(Securities lending income must be quite small, I recall Vanguard rebate all their securities lending profits to share/unit holders and their tracking difference is 0.001% negative, though there will be some costs not included in the OCF)
I’d always known about tracking difference with index funds but should one expect the tracking difference to remain relatively stable from year to year? You suggest looking at the longer 3-yr figure, rightfully so, but is it worth looking at the deviation year to year? Maybe they’re slow/fast to react, or something like that?
It’d be nice to get a 10yr or longer figure though, 3 yrs still makes it possible to make enough bad measurements to affect it.
Nice article, TA. Thanks.
I think that with a lot of these low cost funds — particularly their ETF varianet — the spread is starting to be the thing to be looked at. I’ve not seen a good analysis of that anywhere — has anyone?
When I posted on this previously, my measure was spread measured in days return — that allows comparison across broad asset classes — as well as a good feel for how that cost is amortized over the lifetime of the holding.
For example VUKE is showing as 26.395/26.420. I might expect 7% long term return as it is an equity class. So that’s 5 days.
I think the L&G outperformance may be attributable to the fact that they fix their price at midday, not the end of the day. This means that their performance is affected by what happens during the time between their price being fixed and when the FTSE is fixed.
It doesn’t sound like much. But I have held the L&G and Vanguard UK index trackers for some time and compared their performance. Whilst L&G is outperforming now according to my records they significantly underperformed Vanguard from 2010 to 2013.
Very interesting article on something it’s easy to miss – thanks.
Sorry to be picky – I appreciate you caveated this with ‘meaningful difference’ – but unless it’s changed I thought that the FTSE and MSCI EM indices WERE very different i.e. they had different views on what constituted an ‘Emerging’ market i.e. South Korea, which is quite a chunk.
Are you sure the 3 year TD figures you quote are accurate? The Trustnet table gives -1.13 for L&G UK Index I Acc as per the performance tab at
http://www.trustnet.com/passive-funds/uk-equities.html
Vanguard FTSE U.K. All Share Index A Acc GBP comes in at -0.91 over three years and poor old Fidelity Index UK P languishes at -1.30.
Am I missing something?
@ Fremantle – looks like these figures have changed a lot since I wrote the post which was over a week ago.
Hmm, looks like the numbers could be quite volatile. Worth keeping an eye on.
The top 5 widely investible funds by 3 year TD would now be (as of 19 Jan 2016)
Vanguard
HSBC
L&G
Lyxor
Old Mutual & Royal London in equal 5th
So even more than OCF, it seems that it isn’t worth sweating every basis point of difference between funds but just get one from the competitive set.
I remember a few years ago there was massive volatility in emerging market tracking difference. I can’t remember exactly why but the difference between the index and the optimised version the trackers were using deviated wildly against the trackers. Something seems to have happened to drive the figures sharply down in the interval between writing and publishing.
@ Jim and Neverland – one thing I use tracking difference for is to see how consistent a performer a fund is. So if it tends to track relatively closely to its index minus OCF then I use that as a proxy for good management.
@ Tom – South Korea is the main difference, you’re right. It’s 16% in MSCI and 0% in FTSE. But that’s 16% of a fund that probably amounts to 10% at most of most people’s portfolios. So it’s worth about 1.6% of my portfolio. Which is neither here nor there really. You may well have some South Korea in your developed world fund if it tracks a FTSE index but will having slightly more or less South Korea in your portfolio work for you or against you? Nobody knows. The next biggest difference is FTSE has 4% more India than MSCI. Which will amount to 0.4% difference in a standard portfolio. Personally I wouldn’t sweat it.
One of tricks employed by sophisticated index houses to achieve positive tracking difference is trading ahead of index changes. Index providers such as FTSE or MSCI are updating their portfolios (constituents and weights) on a fixed schedule, usually quarterly. On the day of publishing index changes the prices tend to be more volatile, but having access to market data it is possible to work out what the the index will look like on the day with reasonable certainty. If chunky rebalancing is due, starting to, say, dump shares ahead of the time reduces the drag. I work for one of companies listed above, not as a fund manager though.
I also thought that L&G’s difference could be due to its pricing at midday.
One other factor that will have affected tracking difference is the change in fees. Vanguard have been consistently low charging since they launched in the UK, but others such as Fidelity used to have much higher charges than they have now. In time the affect will drop out and hopefully we should see an improvement in the performance of the previously higher charging funds.
The Blackrock trackers are missing from the Trustnet site!
Bit of a shame, as I believe these are good.
@Naeclue – are they missing because they’re not ‘top ten’ or just missing ?
I noticed that, because along with Vanguard and L&G you’d imagine they’d be the cheapest !
BlackRock in all categories bar UK, US and Europe. A glaring omission that will hopefully be fixed.
You can use the Trustnet charting tool to see how any missing fund compares against its rivals: http://www.trustnet.com/Tools/Charting.aspx
Thanks TA.
I liked this article…and what I took from it was I can’t go ‘too far’ wrong with Vanguard/ L&G…
In honesty, like a few of us, I need to worry a bit less about tiny differences in cost and worry more about just automating everything and not logging on three times a week ;0)
From what I’ve heard, the tracking difference can vary based on market conditions and what the index itself is doing. If the fund is able to do more securities lending, that can raise revenue and improve tracking difference. If the index has moved some stocks out and others in, the fund has to match and that cost can increase tracking difference. That’s why looking at the 3-year figure like you do is useful. I’d agree with the earlier poster that even longer-term figures like 10-yr might be even more informative.
I think Chariguard UK Equities is a CIF – i.e. a fund for charities to invest in only (not individuals). It is exempt from stamp duty so it may be able to beat the others. It would be useful for Trustnet to show this – perhaps the “legal structure” should be CIF not Unit Trust to make this clear.
The Blackrock funds that are missing are the dirt cheap UK domiciled class D tracker unit trusts, e.g. BlackRock Continental European Equity Tracker, class D. The Trustnet site mentions a few peculiar Lux domiciled Blackrock funds, but these were not the ones I meant.
The Trustnet charting tool is useful though, for example comparing the Blackrock tracker (0.1% TER) against the Vanguard (0.12% TER) tracker shows Vanguard outperfrmed by 0.9% (cumulative) over the last 3 years and 0.4% over the last 5 years. That in itself does not mean the Vanguard fund is superior because they track different indices, the Blakrock fund including emerging markets, the Vanguard just developed markets.
Unfortunately Trustnet do not seem to have the tracking difference for the Blackrock fund. Perhaps that is why they are not yet included in the comparison tool.
Just checked the FTSE All-Share 3 year tracking difference again and the numbers have moved significantly again since Tues. Top 5 is now:
Lyxor
DBX
L&G
Royal London
Vanguard
(these are the top 5 of funds we can readily invest in on platforms.)
Hmm, this is looking less useful than I initially thought.
You’re probably better off with the Trustnet charting tool.
http://www.trustnet.com/Tools/Charting.aspx?typeCode=NUKX,NB:AFIA,NB:AFIB,NB:AFIC
The good thing about it is you get a five year and even a 10 year view where the data is available rather than just 3. You can also plot against indices. Not all but a reasonable set of FTSE indices.
I compare annualised performance.
Leave the chart basis setting as bid-to-bid and dividends reinvested (as long as you are accumulating).
Without the index, you can’t see tracking difference directly but you can see which funds are consistently weakest
I pointed out to Trustnet that the Blackrock trackers were missing and they have told me that they have now been added and should appear in a day or so.
Thanks to Accumulator for mentioning the new Trustnet comparison tool.
I’m very new to investing (just bought into the Blackrock fund as my first investment) but in case others haven’t noticed… this fund seems to be listed separately when you select “FTSE Custom All-Share Net Tax (12:00 UK)” rather than “FTSE All Share”. I can guess what the 12.00 means but how does Net Tax differ from the normal All Share?
Thanks for all of the helpful advice on this great site!