What is Tracking Error?
Tracking error measures how closely a mutual fund’s performance mirrors that of its benchmark index. It’s essentially the standard deviation of the differences between the fund’s returns and the index’s returns over a specific period.
The tracking differences and tracking errors are metrics that can aid in evaluating ETFs for a portfolio. However, to properly use the metrics, one must first grasp what each one represents and how much weight each holds in decision-making.
When considering investment products, annualized fund returns are frequently one of the first things investors look at. However, the performance of ETFs compared to their benchmarks and competing products is essential.
The tracking difference, which can be either positive or negative, indicates how well a fund has outperformed or underperformed its benchmark index.
It’s derived by subtracting the fund’s total return from the benchmark’s total. Because a fund’s NAV total return includes fund expenditures, the tracking difference for index funds is often negative.
The simple, hypothetical example below shows how two ETFs with the same benchmark’s average performance and negative tracking discrepancies compare to a baseline of their benchmark’s average performance.
Fund A was the better-performing vehicle, with a more significant average tracking difference. Fund B had a lower average tracking difference, giving investors a poorer return.
The annualized standard deviation of tracking different data points is used to compute tracking errors. Tracking error reflects how much variability occurs among the individual data points that make up the fund’s average tracking difference. Tracking difference evaluates how much an index product’s return differs from its benchmark index.
In our hypothetical example, the graph below depicts the data points that make up the averages. Tracking error is a metric that compares the distribution of individual data points to the average tracking difference of the fund.
The tracking error for Fund A was more significant. It did, however, produce a better average return. The tracking inaccuracy for Fund B was minor. The average return to investors, on the other hand, was lower.
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Using the tracking error and difference
Maintaining tracking differences and tracking errors in context is critical when choosing the finest indexing ETF for a portfolio. If the total return is a significant criterion, tracking differences in evaluations will likely be more important than tracking errors.
If the consistency of performance is a priority, then tracking errors may be a better option.
What are some factors affecting a fund’s tracking of an index?
Total Expense Ratio: The total cost ratio (TER) of an ETF is the single most accurate predictor of future tracking differences. If an ETF charges 0.5 percent to match an index, then ETF returns should trail index returns by precisely 0.5 percent, ceteris paribus.
Transaction And Rebalancing Costs: Whenever an index’s components are rebalanced; a new company is added or removed. Thus, the ETFs that track the index must alter their holdings to reflect the current condition of the index.
As a result, the ETF must rebalance its underlying shares, incurring trading costs in the process. These expenses are included and covered by the fund’s assets, which increases the tracking disparity.
ETFs that monitor indexes with many stocks, illiquid securities, or frequently rebalance by design will have higher transaction and rebalancing costs, resulting in a more significant tracking gap.
Sampling: Some ETFs choose to keep a representative sample of their holdings. The smallest securities have small weights and have no impact on performance in indexes with thousands of securities.
ETF managers may choose to neglect some of those trivial securities to save money. This can lead to tracking differences.
Cash drag: During the time between when the ETF gets a dividend and when it pays those dividends to owners, the ETF will experience cash drag. i.e., the lag between remittance or reinvestment will have an opportunity cost for the fund.
Investors who want more significant long-term returns could prefer Fund A in the hypothetical case above. Despite its lower average tracking difference, short-term traders seeking higher performance consistency are drawn to Fund B.
In other cases, the trade-off between tracking differences and tracking errors may not be as evident. A superior product would have a minor tracking error and a more significant tracking difference.
Importance of Tracking Error in Mutual Funds
Tracking error is a crucial metric for investors, especially those considering index funds or exchange-traded funds (ETFs). A lower tracking error is generally desirable, as it suggests that the fund manager is effectively replicating the index. However, for actively managed funds, a higher tracking error may be justified if the fund manager aims to outperform the index.
How to Calculate a Tracking Error?
- Calculate the difference: Subtract the fund’s return from the index’s return for each period.
- Square the differences: Square each of the calculated differences.
- Calculate the average: Find the average of the squared differences.
- Take the square root: Calculate the square root of the average to obtain the tracking error.
Benefits of Tracking Error
- Evaluating Fund Performance: Tracking error helps assess how well a fund manager is executing their strategy.
- Comparing Funds: It allows investors to compare the performance of different funds against a common benchmark.
Understanding Risk: A higher tracking error may indicate higher risk, as the fund’s returns can deviate more significantly from the index.
The Role of Tracking Error in Active vs. Passive Investment Strategies
Passive Funds: Index funds and ETFs aim to replicate the performance of an index, so a low tracking error is crucial.
Active Funds: Actively managed funds seek to outperform their benchmark, which may result in higher tracking errors. However, this is not always the case, as some active funds may have low tracking errors while still generating alpha.
Disadvantages of Tracking Error
- Reduced Returns: A higher tracking error can lead to lower returns, especially for funds that aim to replicate an index.
- Increased Risk: Deviation from the index can expose investors to additional risk, particularly if the fund manager makes poor investment decisions.
Higher Costs: Some strategies, such as frequent trading or hedging, can increase costs and contribute to higher tracking errors.
Factors Affecting a Fund’s Tracking of an Index
Several factors can influence a fund’s ability to track its benchmark index:
| Factor | Description |
| Expense Ratio | Higher fees reduce returns, impacting how closely a fund tracks its index. |
| Portfolio Composition | Differences in holdings or weighting compared to the index can lead to tracking errors. |
| Cash Drag | Uninvested cash from dividends or redemptions can hinder performance, causing deviations from the index. |
| Illiquid Securities | Difficulty in buying/selling thinly traded stocks can lead to price discrepancies and tracking errors. |
| Index Changes | Updates to the index require adjustments in the fund, which can incur costs and affect tracking. |
| Management Skill | The experience and decisions of fund managers can influence how well the fund mimics the index. |
| Securities Lending | Income from lending securities can offset tracking errors but may introduce variability. |
| Currency Hedging | Costs associated with hedging currency risks can affect performance relative to the index. |
| Transaction Costs | Frequent buying and selling of securities can increase costs, impacting overall returns. |
| Market Volatility | High volatility can affect the fund’s ability to track the index closely due to rapid price changes. |
FAQs
What is tracking difference, and how does it impact ETF performance?
Tracking difference refers to the variance between an ETF’s performance and its benchmark index. Either it can be negative or positive, based on whether the ETF outperforms or under-performs the benchmark.
A significant tracking difference suggests that the ETF is not effectively tracking the index, which can affect its overall performance.
How can investors utilize tracking differences and tracking errors to choose an index fund?
Investors can employ tracking differences and tracking errors to assess the effectiveness of an index fund in replicating its benchmark index.
A small tracking difference and tracking error indicate that the fund closely tracks the index. Conversely, a substantial tracking difference and tracking error suggest that the fund is not effectively tracking the index.
Consequently, investors should opt for index funds with minimal tracking differences and tracking errors to ensure that they obtain the anticipated returns.
What is tracking error, and why is it crucial for investors to consider?
Tracking error is the standard deviation of the disparity between an ETF’s returns and its benchmark index. It measures how closely the ETF mirrors the index.
A high tracking error indicates that the ETF is not closely tracking the index, which can result in unexpected profits or losses for investors. Therefore, it is essential for investors to consider tracking errors when selecting an ETF.
