The ideal method for comparing the cost of index trackers is tracking error [1] not the commonly cited but flawed Total Expense Ratio [2] (TER).
Tracking error enables you to dig beneath superficial differences in TER to unmask deeper cost divides between tracker funds.
These cost gulfs can have a significant impact on your eventual returns, as demonstrated by doing a tracking error comparison [3] between three of Britain’s cheapest FTSE All-Share trackers.
But how important is this information, and how can you conduct tracking error comparisons with your own funds?
Read on! But before you do, please check out that FTSE tracker comparison [3], and take a look at this piece about tracking difference [4].1 [5]
To briefly recap our previous results, we analysed the returns of three FTSE All-Share trackers against their benchmarks:
[6]
The Vanguard [7] fund was the clear winner with a tracking error of 0.07% in the last year. The HSBC fund came in a distant second (0.5%), and the Fidelity fund trailed in dead last (0.82%).
How to decide if you are in the wrong fund
So is that job done? Should passive investors across the nation stampede out of their Fidelity FTSE All-Share trackers and into Vanguard’s?
AHAHAHAHAHA! You and I both know it’s never so simple. Where’s the fun in a straightforward decision like that?
Here’s the pros and cons of leaping into action based on the result of our tracking error comparison.
Pros:
- The Vanguard fund bastes its rivals by similar margins in both years that data is available for.
- Vanguard rebalances its fund more frequently to help it stay true to the index. (Vanguard rebalances daily, HSBC quarterly, and Fidelity when the index rebalances).
- Vanguard lends out the fund’s underlying stocks to other market operators. This practice earns commission for the fund that reduces its overall cost and thus its tracking error. Vanguard’s policy enables it to lend out 100% of the fund’s stocks.
- All of the stock-lending [8] proceeds are returned to the fund – Vanguard doesn’t snaffle any of the upside for the management company’s profit at the expense of its investors. This is so generous, it makes the Good Samaritan look like a git.
- 100% of the Vanguard fund’s stocks may be lent. This is good if you like having your costs reduced, but bad if you’re not so keen on stock-lending risk [9].
- HSBC will lend up to 70% of its fund’s stock, but it only returns 75% of the proceeds to the fund. The rest goes to HSBC, even though it’s the investors who are on the hook if HSBC can’t get the stocks back.
Cons:
- Tracking error is unlikely to stay constant year in, year out.
- Only two years of data is available for the Vanguard fund. Ideally we’d have five.
- If you’d rather your fund doesn’t hawk out its assets for money then go for Fidelity – it doesn’t lend out any stock from the fund.
- Comparison data may not be 100% reliable.
Tracking error DIY guide
Rather than me clouding the issue with pros and cons and ifs and buts, it might help you to decide if you recreate your own tracking error play-offs.
You can do this by comparing index trackers [10] against their benchmark returns on your favourite chart comparison tool.
[11]
I used Hargreaves Lansdown’s charts because they are fabulously user-friendly and they present the returns information in a ready-to-eat table format:
- Search for a fund on Hargreaves Lansdown and click through to its ‘Overview’ page.
- Click on the ‘Charts and performance’ tab.
- Go to ‘Add to chart’ and add your index [12].
- Add your funds, making sure you click on the right version. E.g. Acc for accumulation [13] units and Inc for income units.
- Also look out for R or Ret for retail funds, as opposed to Inst for institutional funds.
- Add ETFs by clicking on Equity in the ‘Choose your investment’ section.
- Type in the three or four letter ticker symbol for the ETF. e.g. ISF2 [14]. (You’ll find the symbol on the ETF’s factsheet.)
- Compare your tracker’s year-by-year returns and cumulative returns against the index.
- Tracking error equals the difference between the index’s return and your tracker’s return.
Obviously the tracker that hugs the index the closest is doing the best job.
In fact, even if your fund is trouncing its index then you’ve got problems, because it’s not doing the job you’ve bought it for. As with mutants, for trackers any deviation is bad.
Make sure you’re comparing the tracker against the index referenced as its benchmark on its factsheet – otherwise the comparison is unfair.
Note that there are even different versions of the same index. So choose the Total Return flavour if you reinvest your dividends, the Price Return index if you don’t.
Tracks of my tears
Plotting tracking error comparisons can be more frustrating than trying to penetrate a call centre telephone menu while The Entertainer plays on perpetual loop.
Matching up FTSE All-Share trackers is reasonably easy because the FTSE All-Share index is recognised by the financial tools available to retail investors.
You are equally in luck if you want to compare against the FTSE 350 Beverages index or the Oslo All-Share.
But comparing emerging market trackers against the MSCI Emerging Markets index? Forget it. Trustnet won’t let you do it, nor Morningstar, Yahoo Finance, or Hargreaves Lansdown. Google Finance will but the results are laughably wrong.
The best I’ve managed in these situations is to plot fund returns against each other to see how synchronised they are, then compared that with published factsheets to see how tightly each fund usually performs against its benchmark.
At least that enables me to see the differences in fund performance, and I can estimate how effectively they track the index. It’s not great but it’s the best I can find right now. If anyone knows better I’d love to hear from you.
There are plenty of factors to consider when choosing a tracker [15] but tracking error is the most important, which makes it a mighty shame that it’s so hard to get clean data for many indices.
Acting on tracking error data is partly a judgement call, partly guesswork, partly deciding on your own tolerance levels.
Personally, if I know I can buy something for half the cost elsewhere then it’s time to swing into action.
Take it steady,
The Accumulator