Passive investing is one of the simplest and easiest ways to invest in the stock market. Instead of trying to beat the index, passive funds simply aim to track its performance.
You'll likely come across two phrases when looking at investing in passive funds – 'tracking difference' and 'tracking error'. Both are used to describe the way a passive fund tracks its benchmark. Unhelpfully, they're often misused or used interchangeably which can be confusing.
We take a look at what each of the phrases mean and how they can be used to analyse passive funds.
This article isn't personal advice. If you're not sure if an investment is right for you, seek financial advice. All investments can fall as well as rise in value, so you could get back less than you invest.
What's the difference?
Tracking difference is a passive fund's performance compared with its benchmark over a certain period. It tells you the extent to which a fund has over or underperformed its benchmark.
For example, if a benchmark returned 10% over a year and the fund returned 9.98%, then the tracking difference for that period would be -0.02%.
Because a fund's total return includes fund expenses, tracking difference is usually negative for passive funds.
Tracking error gives us the consistency of a passive fund's tracking difference over the same period of time. It measures the extent to which a passive fund's return differs from its benchmark. It's the annualised standard deviation of the tracking difference data points for the given time period.
How are tracking difference and error influenced?
As tracking difference measures the performance of a fund versus its benchmark, it's often influenced by things like:
- Charges, including the ongoing costs associated with the fund. This will include the manager's annual charge.
- Taxes – on dividends and within the fund.
- Transaction costs like dealing commissions.
- Securities lending, where the owner of shares or bonds temporarily lends them to a borrower. In return, the borrower transfers other shares, bonds or cash to the lender as collateral and pays a borrowing fee. This can be used to help offset some of the fund's management charges.
Tracking error on the other hand can be influenced by:
- When a fund is valued versus its benchmark. For example, if a fund values at 12:00pm but the market it tracks closes at 4:30pm, there's opportunity for market slippage during that period. This can result in performance looking different to the benchmark.
- Swing price policies, which are mechanisms used to spread the cost of sales and purchases of a fund. They're usually designed so that remaining shareholders in the fund don't bear all the costs when lots of investors try to sell or buy units in the fund at the same time.
- Cash drag – when a portion of the portfolio is held in cash rather than invested, it can drag on performance and keeping up with the benchmark. Passive funds will have cash for a number of reasons, like when the fund receives dividends or to use to trade. Unlike passive funds, indexes won't hold cash.
- How the fund manager replicates the benchmark – whether they buy every holding in the benchmark, or a certain number to represent its performance instead.
Measuring performance
When it comes to measuring fund performance, ultimately investors are more interested in tracking difference than tracking error. That's because tracking difference is what affects the total return you receive on your investment and would indicate how well the fund's done in returning the same performance as its benchmark.
However, tracking error is still important. A high tracking error could indicate that future tracking difference could be high too, so it's always worth paying attention to when looking at passive funds.
The best passive fund would have both a low tracking difference and a low tracking error.
Remember as with any investment there are no guarantees and past performance is not a guide to the future.
If you want to learn more about passive funds, take a look at our Help & Support.