At first glance, an index tracker’s objective may seem quite simple – to reproduce the performance of its underlying index as closely as possible. In practice, however, it means turning a theoretical portfolio into a real investment fund, with all the challenges that presents.
One of those challenges is costs, which come out of index funds’ performance. Trackers’ running costs include dealing and trading fees charged when the fund portfolios are periodically rebalanced to ensure that they accurately replicate the composition of the indices they track.
|"Tracking means turning a theoretical portfolio into a real investment fund, with all the challenges that presents."
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Fund providers use a range of techniques to minimise their running costs and improve the performance of their funds. ‘Tracking difference’ and ‘tracking error’ are the two most widely used indicators to measure how well an index fund has tracked its benchmark.
Tracking difference: This compares the fund’s return to the performance of its underlying index over a period of time. It looks at how closely a passive fund tracks its index. If, for example, an index tracker returned 8.5% over a period of time compared with the underlying index’s 10% over the same period, the tracking difference in this instance will be -1.5%.
Tracking error: This looks at the consistency of tracking difference over time. It is calculated as the annualised standard deviation of the difference between the fund’s daily performance and that of its underlying index. Tracking error is a measurement of risk that defines how consistent the return difference between the fund and its benchmark index has been over time.
Both measures are related, in the sense that tracking error would measure the volatility in the fund’s tracking difference. However, in mathematical terms, they are quite different. Tracking difference can be either a positive or negative figure as it reflects the amount of outperformance or underperformance against the benchmark index. In contrast, tracking error is an absolute figure of variation which does not show the direction of the tracking difference, but only the extent of its volatility.
This article is based on Index tracker funds, an HSBC Global Asset Management guide. To see the firm’s library of passive-related guides and other literature, please click here
The point about pricing points
In most cases, tracking difference and tracking error provide helpful metrics in selecting an index fund. There are some instances, however, when calculations from independent data providers are based on prices taken at different times of the day, which does not provide an equal basis for making a like-for-like comparison. This is because some investment managers price their funds at midday, while others do so at market close.
Both tracking error and tracking difference should form an important part of any due-diligence of index-based funds. However, it is also important to understand what the figures are based on in each particular case. Making like-for-like comparisons between funds priced at different times is unlikely to produce a fair result. If in doubt, it is always advisable to use the figures provided by the fund management company.