We’ve seen how index funds are usually preferable to ETFs when it comes to simplicity [1] and costs [2]. But does either passive approach [3] 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) [4] means nothing if you don’t reckon for tracking error [5].1 [6]
It is a tracker’s job to hug its benchmark index [7]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 [8] of synthetic ETFs before taking the plunge.
In terms of index funds versus ETFs [9], 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 [10]?
Take it steady,
The Accumulator
- 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! [↩ [15]]