The tracking difference and tracking error are mostly widely used, next to cost when analysing index funds. Tracking error and tracking difference are often used interchangeably whilst analysing the index funds. However, tracking difference and tracking error are not the same.
For passive investor, the index funds with low cost is always the preferred funds to invest. Cost of the funds is ofcourse important as over the time, the cost creep up the returns.
However, there are some other factors need to be analysed when choosing the right index fund to invest. Like tracking difference, tracking error, and fund size as these carry hidden cost of an index fund.
Therefore, it is crucial to understand these terms and its use when choosing index funds to invest.
Tracking Difference and Tracking Error
Tracking difference is simply the difference between the returns of an index funds and its benchmark index over a time period.
Below illustration is an example of tracking difference. In this example, Vanguard FSTE 100’s annualized return over 5 years is 0.45% less than its benchmark index ‘FSTE 100 index’. Hence, the tracking difference is 0.45%.
In other word, it measures the total returns of a product in relations to its benchmark over a time period. Rather, measuring the consistency of product performance.
NB: This is not a real data.
Whereas, tracking error of an index fund is defined as the standard deviation of the data point of tracking difference over a time period.
Tracking error denotes the variations in the individual data points of tracking difference that forms an index fund’s average tracking differences. In other words, it measures the consistency of a product performance rather than the total returns.
Using Tracking Difference and Tracking Error to Choose Index Funds
Tracking difference is more relevant when total returns is important to you if you aim is to achieve higher long-term return.
Whereas, the tracking error is more relevant for short-terms traders. Because, it focus on the performance consistency which is quite important for short-term returns.
A fund’s tracking difference can be lower but the tracking error can be higher. For example, HSBC American Index fund has lower tracking but an higher tracking error over 5 years period.
The tracking difference of HSBC American Index fund for 5 years period is -0.54%. The tracker error is 5.10% for 5 year period.
The tracking difference less than 1% is a best product to invest.
In that case, can HSBC American Index fund considered a good product to invest?
The answer can be a simple yes but there are complications to it when you look at its tracking error which is very high. Savvy investors or gurus, suggest that a fund should have a tracking error less than 2% to qualify as a better product.
Only very few superior products such as Vanguard index funds have both low tracking difference and tracking error. So, would it not be a simple choice to go with Vanguard’s index fund? Why even analyse other products?
There comes the cost in equation. Product providers are reducing cost to beat the competition which is good for investors. For instance, HSBC American index fund’s on-going charges or OCF is 0.06% which is less than the cost of Vanguard’s U.S. Equity Index Fund GBP Acc.
Obviously performance of the product should not be compromised for the cost. However, a fund with low tracking difference (less than 1%) but an higher tracking error is not a bad product to invest in. Especially, when you get an equivalent product with low tracking difference at a better cost. Ultimately, you want to invest in a product which provides higher returns with a lowest cost.
NB: This is not a promotion of HSBC American Index fund. This fund is used for illustration only.
What others funds can you find with low tracking difference but has a high tracking error?