Tracking error and tracking difference, what they are and which one is more important
Posted: Wed Dec 11, 2024 10:38 am
Tracking error and tracking difference are two common metrics to refer to when analyzing and choosing an ETF or index fund.
Although their names are similar, they measure different things.
It is important to know what each one represents and which one may be more important for what we are looking for as investors.
Table of Contents
What is tracking difference?
What is tracking error?
Other considerations on tracking difference and tracking error
At inbestMe we give more importance to the difference in monitoring
What is tracking difference?
The tracking difference of an ETF or index fund compares its performance against its benchmark or reference index over a given period of time.
In other words, it is the difference between the profitability of the fund and the index and we could define it with the formula:
Index return – Fund return = Tracking difference
If our primary concern is the total return of an ETF or index fund or investment portfolio, tracking difference is the most relevant measure for us.
This is generally the measure that we give the most importance to when evaluating an ETF or index fund at inbestMe, it best reflects the total internal cost of an ETF or index fund, beyond the TER, as we already told you here .
Bloomberg
Source Bloomberg
For example, in the graph above we see how in the period 6/30/2017 to 3/31/2022:
The MSCI Europe Index has had a cumulative return of 36.84% or 6.82% APR.
The iShares Europe Index Fund (IE00BDRK7L36) has had a tracking difference relative to the index of:
36.84%-35.55%= 1.29% in the selected period.
6.82%-6.61% = 0.21% APR or annualized.
The Vanguard European Stock Index fund Institutional gambling data hong kong Plus (IE00BFPM9L96) has had a tracking difference relative to the index of:
36.84%-34.99%= 1.85% in the selected period.
6.82%-6.52%= 0.30% APR or annualized.
From a tracking difference perspective, the iShares Europe Index fund outperforms the equivalent Vanguard European Stock Index fund by 0.56% cumulatively or 0.09% APR (0.30%-0.21%=0.09%).
Tracking error benchmark
Fountain:Vanguard
In the graph above we see a simplified graphic representation of the tracking difference of a fund A (yellow) and a fund B (black) with respect to an index (in red).
Fund A would have had a better performance for investors than Fund B, being closer to the index, since its tracking difference with respect to the index is smaller.
In the example we have used, the iShares Europe index fund would be fund A. While the Vanguard European Stock Index Fund would be fund B.
ETFs Investment Guide
What is tracking error?
Unlike the tracking difference, the tracking error measures the consistency of the tracking difference over a period of time . That is, it is the annualized standard deviation of the tracking difference over a period of time.
Continuing with the previous example, according to Bloomberg, the iShares Europe Index Fund has a tracking error of 0.075 , while the Vanguard European Stock Index fund has a higher tracking error of 0.403.
While tracking difference measures the degree to which an indexed product's performance differs from its benchmark, tracking error measures the degree of variability that exists between the individual data points that determine the fund's average tracking difference.
Tracking error on funds
Fountain:Vanguard
As we see in the graph, fund A has had a higher tracking error (the points are more dispersed).
Despite this, its tracking difference is smaller and, therefore, it has given a better return for investors.
While fund B, despite having a lower tracking error (the points are more concentrated around their average), has had an inferior performance, its tracking difference is greater with respect to the index.
Other considerations on tracking difference and tracking error
Differences in indexing methodologies and the methods used by fund and index providers to calculate performance can make comparisons difficult.
Often two indexed products, although exposed to the same asset class or macro-geographic region (for example Europe in our example), may be using different benchmarks, which makes comparison difficult. This occurs, for example, in the case used above, in the case of tracking error.
In addition, tracking difference and tracking error are derived from period-wise return calculations.
These calculations are heavily influenced by the pricing mechanisms used to determine the initial and final values of the time periods in question.
For example, they may be influenced by the use of different pricing techniques such as dual pricing or swing pricing.
The pricing methodologies used for index funds may not have a direct relationship to an investor's actual performance and may determine some of the differences.
At inbestMe we give more importance to the difference in monitoring
At inbestMe we believe that the difference in profitability, and therefore the difference in monitoring, is what is most relevant for our clients and most in line with the medium and long-term vision of our investment portfolios.
That is why, following the example used, although the TER of the iShares Europe Index Fund (0.10%) is slightly higher than the Vanguard European Stock Index fund (0.08%), we prefer to choose the former for our portfolios because its tracking difference is better.
Put another way, in reality, even though the iShares fund's TER is 0.02% higher, the total cost of the iShares fund is 0.09% lower than Vanguard's.
In this case, the tracking error is also better for iShares. That is, in both measures the iShares fund would be better. But if this were not the case, we would give more importance to the difference in tracking than to the tracking error.
It is important to note that tracking difference and tracking error are just two of the many measures that investors can consider when selecting the best ETF or index fund for their needs.
Although their names are similar, they measure different things.
It is important to know what each one represents and which one may be more important for what we are looking for as investors.
Table of Contents
What is tracking difference?
What is tracking error?
Other considerations on tracking difference and tracking error
At inbestMe we give more importance to the difference in monitoring
What is tracking difference?
The tracking difference of an ETF or index fund compares its performance against its benchmark or reference index over a given period of time.
In other words, it is the difference between the profitability of the fund and the index and we could define it with the formula:
Index return – Fund return = Tracking difference
If our primary concern is the total return of an ETF or index fund or investment portfolio, tracking difference is the most relevant measure for us.
This is generally the measure that we give the most importance to when evaluating an ETF or index fund at inbestMe, it best reflects the total internal cost of an ETF or index fund, beyond the TER, as we already told you here .
Bloomberg
Source Bloomberg
For example, in the graph above we see how in the period 6/30/2017 to 3/31/2022:
The MSCI Europe Index has had a cumulative return of 36.84% or 6.82% APR.
The iShares Europe Index Fund (IE00BDRK7L36) has had a tracking difference relative to the index of:
36.84%-35.55%= 1.29% in the selected period.
6.82%-6.61% = 0.21% APR or annualized.
The Vanguard European Stock Index fund Institutional gambling data hong kong Plus (IE00BFPM9L96) has had a tracking difference relative to the index of:
36.84%-34.99%= 1.85% in the selected period.
6.82%-6.52%= 0.30% APR or annualized.
From a tracking difference perspective, the iShares Europe Index fund outperforms the equivalent Vanguard European Stock Index fund by 0.56% cumulatively or 0.09% APR (0.30%-0.21%=0.09%).
Tracking error benchmark
Fountain:Vanguard
In the graph above we see a simplified graphic representation of the tracking difference of a fund A (yellow) and a fund B (black) with respect to an index (in red).
Fund A would have had a better performance for investors than Fund B, being closer to the index, since its tracking difference with respect to the index is smaller.
In the example we have used, the iShares Europe index fund would be fund A. While the Vanguard European Stock Index Fund would be fund B.
ETFs Investment Guide
What is tracking error?
Unlike the tracking difference, the tracking error measures the consistency of the tracking difference over a period of time . That is, it is the annualized standard deviation of the tracking difference over a period of time.
Continuing with the previous example, according to Bloomberg, the iShares Europe Index Fund has a tracking error of 0.075 , while the Vanguard European Stock Index fund has a higher tracking error of 0.403.
While tracking difference measures the degree to which an indexed product's performance differs from its benchmark, tracking error measures the degree of variability that exists between the individual data points that determine the fund's average tracking difference.
Tracking error on funds
Fountain:Vanguard
As we see in the graph, fund A has had a higher tracking error (the points are more dispersed).
Despite this, its tracking difference is smaller and, therefore, it has given a better return for investors.
While fund B, despite having a lower tracking error (the points are more concentrated around their average), has had an inferior performance, its tracking difference is greater with respect to the index.
Other considerations on tracking difference and tracking error
Differences in indexing methodologies and the methods used by fund and index providers to calculate performance can make comparisons difficult.
Often two indexed products, although exposed to the same asset class or macro-geographic region (for example Europe in our example), may be using different benchmarks, which makes comparison difficult. This occurs, for example, in the case used above, in the case of tracking error.
In addition, tracking difference and tracking error are derived from period-wise return calculations.
These calculations are heavily influenced by the pricing mechanisms used to determine the initial and final values of the time periods in question.
For example, they may be influenced by the use of different pricing techniques such as dual pricing or swing pricing.
The pricing methodologies used for index funds may not have a direct relationship to an investor's actual performance and may determine some of the differences.
At inbestMe we give more importance to the difference in monitoring
At inbestMe we believe that the difference in profitability, and therefore the difference in monitoring, is what is most relevant for our clients and most in line with the medium and long-term vision of our investment portfolios.
That is why, following the example used, although the TER of the iShares Europe Index Fund (0.10%) is slightly higher than the Vanguard European Stock Index fund (0.08%), we prefer to choose the former for our portfolios because its tracking difference is better.
Put another way, in reality, even though the iShares fund's TER is 0.02% higher, the total cost of the iShares fund is 0.09% lower than Vanguard's.
In this case, the tracking error is also better for iShares. That is, in both measures the iShares fund would be better. But if this were not the case, we would give more importance to the difference in tracking than to the tracking error.
It is important to note that tracking difference and tracking error are just two of the many measures that investors can consider when selecting the best ETF or index fund for their needs.