How to Track Down Tracking Error

How do you measure the performance of an index fund? That sounds like a simple question, but it’s one I think many investors still have trouble with. Otherwise I wouldn’t routinely get questions like, “How can you recommend US and international index funds when they have performed so poorly over the last 10 years?”

If you’re an index investor, your goal is to capture as much of the market’s return as possible. And since investing is never free, that means you’ll likely trail the market indexes by 20 to 60 basis points annually. That may sound like it’s setting the bar low, but the evidence is overwhelming that the majority of investors do much worse, whether they use actively managed mutual funds or pick individual securities.

None of the TD e-Series index funds, for example, has ever beaten the market. Yet they continue to outperform the vast majority of their peers: four of the six core funds in the e-Series family were first-quartile performers over the last 10 years, while the other two were in the second quartile.

So let’s return to the question of how you measure an index fund’s performance. First, let’s agree that a passively managed fund cannot be held accountable for the returns of the market. That would be like blaming the thermometer if the weather isn’t to your liking. Rather, an index fund must be judged according to how closely it tracks its benchmark index. The measure of success, then, is low tracking error.

Fees are not the only cost

I like to think of tracking error as the most complete measure of an index fund’s cost. Most investors focus on MER, and this annual fee is certainly the place to start. But a fund with a low MER and a consistently high tracking error is still expensive. Whether you’re lagging the index because of fees or because of the manager’s inability to track the index doesn’t much matter in the end. Your returns suffer either way.

Of course, index funds and ETFs with low management fees have much smaller obstacles to overcome, so they tend to have lower tracking errors as a result. But that’s not always the case. Some funds have less obvious expenses, such as sampling error and currency hedging in international funds. ETFs that use derivatives—such as forward contracts, swaps and commodity futures—often have significant trading expense ratios (TERs), the lesser known cousins of the MER.

Some indexes, by their nature, are just harder to track. Cap-weighted equity indexes such as the S&P/TSX 60 and the S&P 500 are much easier to replicate than fundamentally weighted or equal weighted indexes, for example. Bond indexes may be impossible to mimic perfectly, so the skill of the manager is more important than investors may realize.

Where to track down tracking errors

How do you find a fund’s tracking error?  iShares is the only ETF provider that offers a useful tool: visit the website and click Tracking Error Chart in the Resources box at the top right of the screen. Then choose any ETF from the drop-down menu and select the time period you want to examine.

For BMO funds, you can visit the web page for the individual ETF, click the Prices & Performance tab, and then click Tracking Error Chart. But the graph simply overlays the performance of the index and the fund, without providing any numbers. That makes to tool rather useless.

Claymore and Horizons do not have tracking error tools on their websites.

The most reliable way to check a fund’s tracking error is to get its Management Report of Fund Performance. This document is published semi-annually and is available on the provider’s website or from SEDAR. Under the heading Results of Operations, the report will disclose the fund’s annual return and compare that to its benchmark.

The final 2010 reports appeared earlier this month, and I looked up the tracking errors of most major index funds and ETFs. I’ll post the results later this week.