What causes tracking errors?
There are several causes of tracking errors. The first is expense ratios, the percentage of the investment charged as a fee. A high expense ratio fee can cause the fund’s returns to lag behind the benchmark index, resulting in a tracking error.
A related reason is trading costs. The costs associated with buying and selling securities can also contribute to tracking errors. These costs include brokerage fees, bid-ask spreads, and market impact costs, which can all reduce a fund’s returns and lead to tracking errors.
Changes in market conditions can also cause tracking errors. For example, during periods of high market volatility, the price of individual securities may fluctuate rapidly, making it difficult for a fund to track the performance of its benchmark index accurately.
Corporate actions such as mergers, acquisitions, and spin-offs can also cause tracking errors, as the composition of an index may change due to these events.
Finally, index rebalancing can also contribute to tracking errors. As an index rebalances, the weights of individual securities may change, which can cause a fund’s performance to deviate from that of the benchmark index.
How does this effect an investment portfolio’s performance?
If the tracking error is positive, the portfolio has outperformed its benchmark index, while a negative tracking error means that the portfolio has underperformed.
In the case of a negative tracking error, an investor who has invested in an index fund or ETF that has underperformed its benchmark index will experience lower returns than they might have expected. This can be particularly frustrating for investors who have chosen a passive investment strategy precisely because they believe it will provide returns similar to those of the benchmark index.
Tracking errors can add up over time and significantly impact long-term investment returns. For example, even a small annual tracking error of 0.5% can result in significant underperformance over a period of several years or decades.
What is the acceptable range for tracking error in investment funds and ETFs?
The acceptable range for tracking errors is 4% to 7%. However, some active fund managers take bigger risks and bets so you might see tracking errors as high as 15%. Strategies that focus on absolute returns and do not follow their benchmarks closely are more likely to have higher tracking errors.
What are the main causes of tracking error in index funds?
Apart from fund rebalancing, trading costs, corporate actions, changes in market conditions and expense ratios, there are factors that affect tracking errors in mutual funds specifically. The first is securities lending. Some index funds engage in securities lending to generate additional income. While securities lending can provide additional returns, it can also introduce tracking errors if the securities being lent out do not match the composition of the benchmark index.
The other is cash drag which happens when an index fund holds cash. Such cash is not invested in securities that make up the benchmark index leading to tracking errors.
The timing of dividends can also cause tracking errors. If the dividend payment date falls outside the measured period, the fund’s returns may deviate from those of the benchmark index.
Lastly, how the benchmark index is constructed can also introduce tracking errors. For example, if the index is based on a specific industry or sector, the fund may not be able to fully replicate the index due to the limited availability of certain securities.
Tracking errors have a significant effect on the performance and returns of a fund. Fund managers and investors must know what the tracking errors in specific investments are so they can adjust accordingly.
