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Should tracking error sway the choice between ETFs and index funds?

We’ve seen how index funds are usually preferable to ETFs when it comes to simplicity and costs. But does either passive approach have the edge when it comes to tracking the underlying index?

Low costs are a honeypot for passive investors, but paying a low Total Expense Ratio (TER) means nothing if you don’t reckon for tracking error.1

It is a tracker’s job to hug its benchmark index tighter than long-lost octopi twins. Tracking error (also known as tracking difference) can show us how well any index fund or ETF is doing that job.

Check tracking error for any passive fund

An initial saving on TER can soon be wiped out by a misfiring tracker that deviates wildly from its index.

So if you’re picking between a rival index fund and an ETF on the basis of TER, it’s worth also checking whether their respective tracking error makes the low TER a false economy.

If there’s little to choose between them on a TER basis, then I’d personally go for the tracker with the lower tracking error.

Note that synthetic ETFs are reputed to have a low tracking error due to their unique fund structure. However, they are currently subject to a great deal of regulatory heat and media controversy. Make sure you understand the particular risks of synthetic ETFs before taking the plunge.

In terms of index funds versus ETFs, I’m calling this one a draw. While synthetic ETFs may have an advantage when it comes to tracking error, they also introduce a can brimming with worms that I’d rather avoid when passive investing.

In part 4: Which type of tracker offers the most choice?

Take it steady,

The Accumulator

  1. Note that we have used the term tracking error throughout this post, because that is the term most of the world uses to describe how much a tracker strays from the return of its benchmark index. However what is commonly termed tracking error is more properly called tracking difference. Tracking error is specifically a mathematical measure of standard deviation. In practice the terms are fairly interchangeable, unless you are a quant analyst by profession! []

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{ 5 comments… add one }
  • 1 Paul Claireaux November 8, 2011, 1:00 pm

    Hi there,
    surely the really big issue to watch out for (if and when the balloon goes up) is whether the fund engages in wholesale stocklending. Who it lends it’s stocks out to, how safe they are, what collateral they put etc
    Having a fund (index tracker, etf or otherwise) which has lent out 50% of it’s stock to an investment bank which has only put up dodgy capital (italian bonds ??) must surely present some very nasty risks.
    Ideas on how to mitigate these welcome

  • 2 The Investor November 9, 2011, 1:08 pm

    @Paul – I asked T.A. to keep these posts simple and focused, as I think our longer more detailed and multiple caveat-ed posts are impenetrable for some new investors who want and need simple answers.

    For what it’s worth, I personally think talk of lending risk is overdone. (As with all our posts, that’s not personal advice — please do your own research!) There may be some particular ETF or other vehicle that blows up, but I’d be very surprised at a systemic meltdown that hits the whole passive market on the back of this. Micro-blow ups from specific but limited stock lending operations that go wrong would presumably show up in greater tracking error.

    For me it’s another reason to diversify widely, even if you’re a passive investor, among different banks / managers / security types. Once you’ve got a meaningful sized pot relative to your net income and so forth, I don’t think the asymmetrical risk of having all your money in the fund that blows up is worth it for a simpler life or to save 0.1% TER.

    I used to be a lone voice arguing this in the personal finance blogosphere (the rich on the other hand have always diversified widely) but I think more people are coming to understand it in the light of the credit crunch. Every single investment you make can fail you.

    Anyway, for more thoughts on the specific risks of stock lending, please see T.A.s previous posts on the subject of physical ETF risks and mitigating ETF risks in general.

    We’ve also written about synthetic ETF risks in detail.

    Hope this helps! 🙂

  • 3 Paul Claireaux November 9, 2011, 2:24 pm

    Thanks – yes that is useful reference.
    My view is that the benefits to me of marginally reduced cost (bps pa ) are not worth the risk of large capital losses should the system implode.
    With Italy’s borrowing costs (10 yr money) having spiked up to 7.4% today (a level which most “experts” tell us is unsustainable) then the risk of system failure – if only partial – has increased.

    I’d love to know where i can find equity funds that don’t lend. Apparently they are all at it – OEICs, ETFs, Insurance and pension funds and even if they havent done it in te last year that’s not to say they wont – as you corrrectly point out.

    I’m not sure about good old fashioned Unit Trusts though . . . . what say you ?

    More generally – i find it extremely sad to reflect that various regulators and stability boards seem capable only of quietly making these warnings long after the horse is out of it’s paddock and galloping through the streets.

  • 4 The Investor November 9, 2011, 5:44 pm

    @Paul — I wouldn’t be surprised if most funds lend — it’s one of the things that keeps down TERs, since it makes a small income for managers. And in a top-of-the-table driven world, having a low TER is more important than other small print for most people.

    You could always buy your own shares and hold them directly with some portion of your money, although naturally that opens up new vistas of risk! 😉

  • 5 Paul Claireaux November 9, 2011, 7:37 pm

    Yes – directly holding shares – for those with reasonably sized funds such that the broking fees don’t kill you – is certainly something i’d encourage others to do (and do myself) along with directly holding UK short gilts for money waiting to be invested.
    Cash funds of stockbroking accounts (and in OEICS and Insurance company funds ) have their own risk dyanamics too – and of course do NOT come with deposit holder protection.

    Did you ever do an article on that one – Standard Life Cash fund etc ?

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