NOTE: I’m scrambling to write this before I get on a plane and my laptop battery is near death, so pardon any typos for the time being – I’ll edit it tomorrow, and may even re-write it! It’s good to be my own editor…. :)

Not all index funds are created equal. Some actually track their indices pretty well, and some do a poor job. Most people think that tracking an index would be a relatively simple thing but you know what they say, “in theory, theory and practice are the same but in practice they are not.”

Some sources of index fund tracking errors:

1. Resampling (Or Optimization)

If an index has 500 constituents, then it is impractical to replicate all the holdings when the fund has a small amount of assets. For example when an index fund first starts trading, it may only buy another manufacturer’s ETF to get market Beta until there are enough assets in the fund to actually go out and buy some or all the holdings itself. The index fund manager may also choose to hold a portion of the 500 holdings until the fund gets really big (to minimize transaction costs). How do they pick which stocks to hold and which they don’t? It’s up to them, but one method is to pick a combination of stocks that allow them to replicate the GICS sector allocations in the index (Global Industry Classification Standard). That means that if financials are 20% of the index and consumer discretionaries are 20% and so on, they will pick the combination of stocks that allow them to match those numbers – in this case they are seeking to match sector Betas.

2. Cash Flow timing

When money is added to a fund it must then be deployed into the holdings. In the case of ETFs, if not enough money is added to a fund to buy a creation unit, it might sit in cash until the next day. If the underlying stocks move between the positive cash flow and the cash deployment, this could affect the index fund’s performance. In the case of a mutual fund, the portfolio manager (yes, index funds have them too actually!) might get a small cash flow and not be able to deploy it into all the underlying constituents – they may choose to buy an ETF for market or sector beta, or buy a portion of the underlying constituents and make up the difference the next trading day when new money comes in, or if money leaves the fund for a redemption.

3. Proxies

Some index funds (with foreign exposure) may buy the foreign holdings on foreign exchanges, and some may buy ADRs or GDRs (American Depositary Receipts or Global Depositary Receipts). ADRs trade in the US but may trade at a premium or discount to the actual underlying stock.

4. Market Access

Again, index funds with foreign exposure may have stocks that trade in markets that are closed when domestic markets are open and vice-versa. If the index fund buys the direct stocks, someone has to deploy the cash overnight – it can be the fund custodian who sub-contracts out to a foreign prime broker, or the fund might have an office in that market. But if the fund operates in a different market, they can only receive the money during their hours of operation, so the underlying stocks can change in value between the time the cash comes to the fund and when it gets deployed.

If the fund buys ADRs then you still have the issue of the ADR lagging the movement of the underlying stock since money gets deployed right away, but in a security (the ADR) that can itself be moved by supply-demand issues on the market it trades even though the underlying security is not being traded. Again, this can introduce tracking error.

5. Dividend Drag

This really falls into the cash flow management arena, but instead of the cash flows being due to investors adding or subtracting money from the fund, with dividend drag it is due to the receipt of dividends earned on the underlying stocks being held. The fund receives cash which has to wait to be deployed.

6. Securities Lending Income

Same principle as with dividend drag, except the positive cash flow is due to the income generated from loaning out stocks in the fund to short sellers.

7. Brokerage commissions

The fund itself has to pay commissions to buy and sell stocks, so this will create a drag on returns too.

8. MER

Ah yes, can’t forget this one! The Management Expense Ratio is made up of the Management Fee and Operating Expenses, and of course these will drag down performance of the fund as well.

Conclusion

These are some of the areas which can introduce tracking error and I haven’t even talked about currency concerns. Different index companies tracking the same indices can have dramatically different tracking errors and its certainly something that doesn’t get enough attention. Note that some of these factors may generate positive or negative tracking errors and some (i.e. fees) can only generate negative tracking error. In its purest form, tracking error is the absolute magnitude of the deviation from the index and is not normally referred to as being positive or negative, but breaking it down this way is helpful.