Tracking Passive Investment in the Real World
We need to be mindful of tracking error when assessing passive investment. This article discusses the various ways that tracker funds can mirror the performance of an index and it provides us with an alternate way to identify a good passive investment. This will be useful to anyone studying the CII R02, AF4 or J10 exam.
In an ideal world, the tracker fund performance will exactly match the performance of the index that it’s tracking – so a FTSE 100 tracker will return exactly the same as the FTSE 100. Brilliant – if this was an ideal world. But it isn’t, and we need to be mindful of tracking error, which is how we can measure how well the tracker fund is actually doing – or not.
Firstly, let’s remind ourselves of the ways that tracker funds can mirror the performance of an index.
Physical Replication
There are three established tracking methods which include:
Full replication – This is where the fund buys all the index components – so a FTSE 100 tracker will buy all the companies in the index in accordance with the index weighting.
Stratified sampling – The fund holds a representative sample of securities from each sector of the index.
Optimisation – Uses computer modelling to find a representative sample of securities across the index.
Synthetic Replication
Another method of tracking is synthetic replication – this is where the fund manager uses derivatives such as swaps to track the index rather than physical investment. They enter into a deal with a market counterparty to exchange the return on the index for a payment. This type of tracking method tends to be less common these days due to the risk of using counterparties.
Tracking Error
So back to tracking error, what is it and how do we find out what it is on a fund?
Tracking error is the standard deviation of the difference between the fund’s returns and the returns on the index – it is effectively measuring the volatility of the tracking difference (we will look at what tracking difference is below).
What we are looking for is a low number – the lower the number, the better the fund has matched the index.
The main cause of tracking error is, of course, the costs of running the fund – these are identified in the fund total expense ratio (TER) or ongoing charges figure (OCF) so again, the lower this number, the lower the tracking error.
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Tracking Difference
The problem is finding these numbers in the investor information – some show tracking error clearly – others don’t.
With it being often difficult to find and difficult to calculate ourselves, it may be easier to look at the tracking difference figure instead of tracking error – this is a much easier concept to understand as it is simply the difference between the return on the index and the return of the fund. If the index returns 5% and the fund returns 3%, the tracking difference is -2%. Good investor information from a provider shows both figures.
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