Investor Facts: What Is Tracking Error?

Tracking error is the gap between how a mutual fund, exchange-traded fund (ETF) or index fund performs compared to a benchmark index.

When investors buy a fund they usually understand that they are not buying exactly the same stocks, bonds or other investments that comprise the benchmark. While index funds and many index-style ETFs are designed to replicate a benchmark they cannot do so exactly.

That’s because the cost of owning exactly the same stocks or bonds in exactly the same proportions would be onerous. The cost of the fund would have to go up, eliminating the advantage of indexing in the first place.

Instead, low-cost funds attempt to recreate the benchmark by doing what’s called “sampling” of an index.

If a given benchmark is currently 10% a single large stock, the index fund would make sure that the underlying stock would be 10% of its fund, too. Naturally, this changes constantly.

In some cases there are stocks that are so tiny that owning them in the fund becomes expensive and that outweighs any potential advantage. This is particularly true of small companies and foreign shares that trade for much smaller dollar amounts per share.

In those cases, some funds will establish sectors of stocks — say, technology, manufacturing, consumer goods and so on — and then own a balanced percentage of the largest 10% or top 20% of stocks in each sector.

The fund’s managers create these filters with the goal of reducing cost and simplifying. The result can sometimes be that a benchmark moves by one percentage during a trading day and the fund moves by another.

That might mean you have an S&P 500 fund that ends the day 2% higher while the index itself ends 2.02% higher.

Wrong direction

Tracking error is not a huge problem so long as the differences generally cancel out over a few days or weeks. It’s only when the errors compound in the wrong direction that investors begin to worry that the fund they own might not be constructed efficiently enough.

And then there are the more exotic ETFs that promise to use leverage to create artificial returns in a very short span of time. Instead of owning stocks these funds typically use futures and other instruments to “bet” on the direction of a given asset.

Tracking errors on these kinds of financial products can be very difficult to assess and potentially damaging to investors. Another big problem is liquidity. If an ETF invests in a very small corner of the market that becomes suddenly popular, the wave of incoming investors can quickly distort the fund’s performance.

The lesson for long-term investors is to prefer established funds with long records of reliable performance relative to their established benchmarks. Be aware of tracking error and try to avoid funds that are very new or which attempt to use unpredictable market forces to amplify returns.

MarketRiders, Inc. is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.