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 In Part One of this article, I developed a picture of how traditional published expenses and less visible expenses-the most important of those being transaction costs-adversely affect fund performance. Now, let’s look at a useful framework for analysis of these and other elements affecting fund performance: Tracking error.
What Is Tracking Error?
Tracking error was not widely mentioned in investor and adviser discussions of funds until a large number of exchange-traded funds tracking multiple indexes were available to investors. Index tracking had been discussed in connection with index mutual funds, but the number of index mutual funds was and is small, and the number of indexes used by mutual funds is even smaller. It is useful to discuss the growing interest in index tracking in connection with the growth of index ETFs and then examine how a tracking error framework can be useful in evaluating all types of funds.
Tracking error is one of a relatively small number of financial terms that has been defined differently in different situations. In most academic finance papers, tracking error is defined as “an unplanned divergence between the price behavior of an underlying position or portfolio and the price behavior of a hedging position or benchmark.”1 In these academic applications, tracking error is usually expressed as the expected or experienced one-standard-deviation annualized percentage variation of a portfolio value from a benchmark index value. This definition is used largely to measure how much an actively managed portfolio strays from the benchmark as the manager tries to add value. I will return briefly to this definition later, but it is not the definition used in most discussions of ETF tracking error and it is not the definition we want to use as a framework for fund analysis and evaluation.
In discussing tracking error in the context of exchange-traded index fund returns relative to the fund’s benchmark index, the notion of a standard deviation would not be useful before data for at least several years had accumulated. However, “tracking” comparisons of ETFs are called for and made when ETFs have been in operation for even less than one year. The purpose of such early comparisons is simply to measure how closely the exchange-traded index fund return matches the return of the index. Most fund users neither know nor care about standard deviations, so the comparison fund analysts began publishing was simply the return of the fund minus the return of the index. This difference is usually expressed in basis points (hundredths of a percent) because most index ETFs have tracked their index closely and the difference is usually small.
When a standard deviation is used as the measure of tracking error, the tracking error is always expressed as a positive number. However, the difference between a fund’s performance and the performance of its benchmark can be positive or negative, depending on whether the fund performs better or worse than the index. Understandably, there was some confusion over the sign of a tracking error measure until ETF analysts clarified what they were doing. The tracking error measure used in connection with ETFs today is positive when the fund’s NAV outperforms the index, and negative when the fund under-performs the index.
As a simple example, if a fund return were +8.75 percent for the year and the total return on its benchmark index were +8.65 percent, the tracking error would be reported as +10 basis points. If the returns were reversed, the tracking error would be reported as -10 basis points. Calling this difference “tracking error” seems reasonable and intuitive to ETF analysts and users and it rarely confuses anyone except finance Ph.Ds.
A few people have calculated a “tracking error” as the difference between the market value return of the ETF and the return of the index, but the most frequent comparison is between the net asset value return of the ETF and the return of the index. ETF market prices typically will converge on NAV over any long period, making the long-term difference between the ETF market value and net asset value negligible. While some comparisons are done for shorter periods, the most widely discussed ETF tracking error comparisons are annual.
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