It’s Einstein’s fault, of course.
The theory of relativity has perhaps played a role in the fact that today’s investment world is obsessed with relative performance.
It’s not about how high you can jump, but whether you can jump higher than average. A manager that loses 10 per cent of your wealth is trumpeted as skilful if the index you had exposure to lost 15 per cent over the same period.
This week we’re contemplating the virtues and vices of tracking error: the extent to which a portfolio mirrors a particular index.
In technical terms, tracking error is the standard deviation of the difference between the daily returns of a portfolio and its index. The smaller the difference, the closer the match.
This is not necessarily a good thing: one does not want to match the speed of a runaway train shooting off the edge of a cliff.
However, this is a concept of particular importance to passive investing via so-called tracker funds that unapologetically exist to match the returns of particular indices. A tracking error checks that a fund is doing what it says on the tin and is probably the single most important piece of information a passive investor needs to know in choosing a fund.
The task of replicating the performance of some indices is surprisingly difficult. Certain global bond indices, for example, have more than 5,000 bonds in them.
It is tedious and economically unviable to go out and buy every single one. Instead, passive managers will pick a selection of bonds that closely approximate the risks and exposures of the whole index, a strategy known as ‘partial replication’, which is where tracking error creeps in.
Other indices, such as the FTSE 100, are far easier to track: buy all one hundred shares in the right proportions (full replication) and the index and the fund are one and the same.
Nevertheless, indices live in a magical fantasy world of fee-less investing and free dealings. Tracker funds do not. After fees, the returns of a full-replication tracker fund will always be slightly lower than that of the index it follows.
There’s a hole in my bucket, dear Liza, a hole. Tracking error tells us the size of that hole.
Here are some examples.
The Vanguard FTSE All-Share Index tracker has a tracking error of around 0.04 per cent. That compares with an active fund such as Oriel UK that has a tracking error of 6.24 per cent.
This is how it should be. If an active fund has a small tracking error, this could be assumed to be a closet ‘benchmark hugger’. Closet ‘benchmark huggers’ buy companies not based on their qualities or cheapness, but on their weights in the index.
Why pay an active manager to track an index when it would be cheaper to just use a tracker fund?
