There is a misconception, even among experts, that a low tracking error for a passive fund (index fund or ETF) implies the fund’s returns closely match the benchmark. This is not true.
What is a tracking difference? This is the fund return minus the benchmark total return over a period. This will typically be a small negative number as the fund return will always (well, typically!) be lower than the benchmark return.
For ETFs, only tracking differences should be measured by computing returns using ETF price, not NAV! See ETFs vs Index Funds: Stop assuming lower expenses equals higher returns!
What is the tracking error? How is it computed? The tracking error measures the average return difference between an index fund and its index. It is measured similarly to the standard deviation (volatility measure).
The standard deviation tells you how much a fund’s monthly return (as an example) deviates from the average monthly return. While computing the tracking error, we replace the average monthly return in the standard deviation formula with the index return.
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Why retail passive investors should avoid using the tracking error!
Tracking error is for portfolio managers. It is not an intuitive measure of performance deviations. Tracking errors depend on the measured duration – retail investors rarely appreciate this aspect. Tracking error calculation does not explicitly penalise index funds that beat the index over a short period.
Tracking errors for different durations (like trailing returns) are not readily available. Therefore, it is easier to compute return differences over the last six months, quarters, 1,3,5 years, etc.
Also, if we assume the total expense ratio of a fund is constant throughout computing the tracking error, it will not affect the tracking error value as the same constant amount is deducted from each day’s NAV.
The tracking difference is easier for everyone to appreciate and considers both expenses and difficulty in following the benchmark. Therefore, the tracking difference is intuitively a better metric.
Our monthly index fund tracking error screener data shows us more evidence. A typical 1Y Tracking Error (y-axis) vs 1Y Tracking Difference of 66 index funds is shown below.
Notice a considerable spread of possible tracking differences for the same tracking error value (y-axis) (within the red rectangle). Buying an index fund with a low tracking error but a large tracking difference makes no sense because my return will be considerably different (lower) than the benchmark.
Therefore, Low Tracking Error Doesn’t Guarantee Index Fund Return Matches Benchmark Return
There is also a spread in tracking errors for a small tracking difference. The tracking difference is far from a perfect metric for evaluating passive funds. Still, it is simpler to appreciate and evaluate than the tracking error and represents the ultimate benefit or drawback an investor has to bear while holding the fund.