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See also Do Mutual Fund Benchmarks Matter?.
This fact helps create and drive an index fund’s tracking error. Tracking error is the difference between a mutual fund portfolio’s returns and the benchmark index it was designed to copy. Generally, tracking errors are calculated against the total returns for the specific benchmark—which includes dividend payments—and are reported as a “standard deviation percentage” difference.
For example, if you buy shares in ABC Investments’ S&P 500 mutual fund, which is designed to track the venerable S&P 500, and it returns 5.0% while the S&P 500 returns 5.5%, ABC Investments’ fund has a 0.5% tracking error.
There are several reasons for why an index fund will underperform or—in rare occurrences—outperform their benchmarks. First, all mutual funds hold some cash on their books. This is to help pay out investor redemptions as well as manage inflows into the fund. By holding some cash, the fund is not 100% fully invested in the indexes’ underlying holdings. This cash cushion creates a drag on overall performance.
The biggest drag on performance is usually the fund’s expenses. The expenses we pay to own a mutual fund come out of the fund’s profits and assets, and reduce its overall performance. For example, if the previously mentioned ABC Investments S&P 500 fund charges 0.20% in expenses and the S&P 500 Index returns 10.00%, under a best case scenario, the fund will only return 9.80%. When you add in other fees like front-end sales loads and 12b-1 fees, you are starting to really deviate from the underlying index’s performance.
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Additionally, if an index fund uses a sampling strategy to derive its holdings, it can result in a larger than normal tracking error. In a sampling strategy, the mutual fund will buy most, but not necessarily all, of the stocks within the benchmark index. The idea is that the fund will attempt to closely match the overall investment attributes of the index. A fund manager will make the selections to keep sector weightings and provide a large spread of firms to cover the underlying index. Unfortunately, if the manager “bets” wrong, the fund could have a big tracking error.
Index funds that use a full replication strategy and low expenses—meaning without sales loads—will generally have lower tracking ratios. Therefore, these funds will match their benchmarks more closely. You can compare similarly styled funds to see which ones are better indexers.
Tracking “error” also relates to actively managed mutual funds as well. All mutual funds will select a benchmark that they seek to outperform. Tracking error calculations can be used to see just how much the fund manager is “different” than the fund’s underlying benchmark. That can be used to weed out closet indexers and help investors get more bang for their investment buck.
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Money Market Funds