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Tracking Passive Investment in the Real World

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.

A tracker fund is supposed to match 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 in the real world we need to be mindful of tracking error which is how we can measure how well the tracker fund is actually doing – or not, as the case may be.

Firstly let’s remind ourselves of the ways that tracker funds can mirror the performance of an index.

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 exactly the same weighting.

Partial Replication

If it’s too difficult to buy all of the shares in an index (there are just too many), then partial replication is used where a sample is held which represents the index as a whole.

Synthetic Replication

There is also synthetic replication – this is where swap-based contracts (a type of derivative) are used instead of physical investment – useful where it’s a difficult market, like some commodities, to access.

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 soon).

What we are looking for is a low number – the lower the number, the better the fund has matched the index.

The Cause of Tracking Error

The main cause of tracking error is of course the costs of running the fund – these are identified in the fund TER or OCF so again the lower this number, the lower the tracking error. The amount of trades a fund makes will also impact on costs and therefore tracking error. If a fund can be found with a tracking error which is the same as the cost of the fund, then this would indicate a pretty good passive investment.

 

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An Alternative Figure to Use

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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Over to You…

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