Jose Garcia Zarate: A growing number of investors are turning to passive funds, whether traditional trackers or exchange-traded-funds. The basic concept of passive investing is straightforward: passive funds replicate the performance of an index.
However, investors who are new to the world of passive investing soon find out that there are different ways of measuring how well a fund tracks its benchmark, and it is important to understand the nuances.
Tracking difference and tracking error are the two most important measures of tracking ability. Some investors think that these terms, which are very commonly used in the passive fund industry, are the same. However, they are very different.
Tracking difference is the absolute difference between the returns of the fund and those of the benchmark at the end of the chosen investing period. For example, if you hold a passive fund for three years, the tracking difference is a single measure calculated right at the end of the three-year investment period and tells you what you get relative to the benchmark once you exclude the fund’s charges over the period.
Tracking error, on the other hand, is a measure of how well the fund tracks the benchmark during the investment period. It is a measure of volatility. A small tracking error indicates that the passive fund will tend to follow its benchmark very closely throughout, whereas a large tracking error indicates the opposite.
A useful analogy to understand these concepts is that of race between two cars, where one car is the index and the other is the fund. Tracking difference would be the time difference between the two cars at the finish line. Tracking error tells you how close the two cars were to each other during the race.
The question for many investors is, which one of these measures should I care about? Both have their merit, but at the end of the day, we are more likely to care more about the final outcome.
