Reasons for Index Tracking Errors

Index funds and ETFs have the purpose of tracking a given exchange, or market benchmark. To do this, the fund will typically have a portfolio ownership that is closely in-line with the characteristics of its benchmark (generally based on market capitalization for stock indexes). However, there are some key reasons why passively managed funds can (and do) slightly deviate in actual performance from their benchmarks. Deviations are known as tracking errors, and can be thought of as general inaccuracies in terms of fund performance. These are interesting concepts to dig deeper into, which also depict some fundamental workings of index funds.

A quick note on comparing fund accuracy to a benchmark, recall Beta and R-squared, which are both useful measures to asses the extent of tracking errors. Beta (or Beta coefficient) depicts how much more volatile an index fund is from its benchmark, with 1.0 representing perfect tracking; an index with beta of 1.10 is considered 10% more volatile than its benchmark. R-squared depicts how strongly correlated the benchmark and index are, from 0-100 with 100 representing a perfect correlation. Note that while tracking errors are part of an indexing portfolio, by the nature of being passively managed, these deviations should be relatively minimal (beta close to 1.0 and high R-squared values are expected). Note that another clear indicator of fund accuracy is past performance as compared to benchmark past performance. For the purpose of this article, we will consider index funds and ETFs as one unity and simply refer to them as index funds.

Possible Reasons For Tracking Errors:
- Trading Costs: Any trading costs will result in some reduction in performance and therefore a slightly lower return in the index fund as compared to its benchmark. Having said that, index funds are passively managed, so transactions (and associated commissions) should be very minimal. Regarding trading implications there are other factors such as taxes and exchange rates that can impact fund performance.
- Structure of the Fund: While an index fund will typically be weighed by market capitalization (to mirror its benchmark), there are other indexing strategies such as smart-beta which weighs differently to give investors greater potential return. Such strategies will by default fundamentally deviate the tracking ability of a fund from the base benchmark (you can think of the base benchmark as being shifted for some strategy, for example towards ‘Aggressive Growth’).
- Number of Investments: Along the same lines as the previous point, it is possible for an index fund to include some minor investments outside of its benchmark index. For example, TD903 (Dow Jones Industrial Average e-series index fund) consists of 32 total investments, while there are only 30 companies in the DJIA.
- Cash Drag: Any amount of cash that is held in an index portfolio un-invested will create a fluctuation buffer that will reduce tracking accuracy. Given the nature of index funds, it is rare that any substantial percentage of the portfolio will be cash. One situation where cash drag would be present is due to dividends. These would then typically be shared with investors and/or be reinvested into the fund.

These are some of the key reasons why you can expect an index fund to have slight performance deviations from its benchmark. As an index fund aims to track an index, not beat it, the ability to track a benchmark is thus a fundamental characteristic of fund quality. Being aware of tracking error dynamics can allow individual investors to compare multiple index funds and assess which funds may suit their investment goals and strategies best.

Thank you for reading, if you have any comments of questions please post below! If you have any recommendations for topics also post below or contact me in the form located on this page. Please give the blog a share and follow if you enjoy the content (especially the fantastic handmade graphical example)!

Here are some of our other articles on similar topics:

- Best Index Funds and ETFs (Canada)

- What Exactly is an Index

- E-series Top Holdings Breakdown

-Yinvestors.