By Scott Roark, MBA, PhD | August 30, 2019
Benchmarking vs. Tracking Difference
In a recent podcast episode (Edu #1925), we talked about benchmarking investment performance. It is important for investors to know how well they (or their managers) are doing with the investment decisions they make. One of the reasons that managers may not like to benchmark is that historically, relatively few managers consistently beat their benchmark. There are a variety of reasons it is difficult to beat a benchmark. Benchmarks are typically tied to an index which means it is a passive investment choice. The problem with an index is that you can’t technically invest in one – when you buy an S&P 500 ETF, you are buying something that is very close to the index, but not the same as the index. An index doesn’t have trading costs, taxes, manager fees, rebalancing costs and a variety of other possible drags on performance. But you can generally feel pretty good when you buy your ETFs because the correlation between it and the index you are trying to mimic is usually higher than 99%+.
A similar way of stating the performance of an ETF and an index are very close is to look at their tracking difference (the difference between the index performance and the fund/ETF performance). A good ETF or index mutual fund will have a very low tracking difference – measured in 1/100ths of a percent. So for example, say the Russell 2000 index had a return of 7.59% and your Russell 2000 ETF had a return of 7.52%. The tracking difference, in this case, would be 0.07%. If you are trying to mimic the performance of an index by purchasing ETFs or mutual funds, the tracking difference is an important piece of information.
Using Tracking Difference
There are dozens of funds and ETFs (from dozens of fund companies) that track the S&P 500 for instance. An investor might reasonably expect that when they purchase an S&P 500 fund, they will be getting a performance that very closely resembles the results of the S&P 500 index. With many funds, that is what you are getting – something that very closely resembles the S&P 500 and has a tracking difference of 0.10% or less.
However, there are funds – typically ones with high expense ratios – that have relatively high tracking differences and really aren’t giving investors what they should be expecting. One notorious example of an S&P 500 index fund has an expense ratio above 2.3%. Compare this to many funds and ETFs that track the S&P with expense ratios of less than 0.1% and you can start to see why the fund’s returns will be well below the benchmark and there will be a large tracking difference.
What Else to Consider
In closing, I’ll mention one last factor that is related to investment performance – particularly for mutual funds. That is the tax-efficiency of the fund. This is related to the buying and selling of the fund and how that affects the taxable distributions from the fund each year. If you are holding your investments in a tax-advantaged or qualified account (an IRA/401k/Roth), you may not care that much about this. But in a taxable brokerage account, taxes represent a very real decline in investment performance. The fund I mentioned above that had expense ratios (for an index!) over 2.3% also had an annual turnover of 157% (versus 4% for more well-run index funds) – there was a lot of buying and selling. All this trading means that come tax time, there will likely be insult added to injury and the after-tax performance will be VERY far away from what the index return was.