November 26, 2012

Why You Shouldn’t Be So Worried About Tracking Error

A few weeks ago we began a discussion on portfolio management. In my first posting, we discussed how it is possible to be too diversified. Last week we uncovered a major flaw in some advisors' use of Monte Carlo simulation. This week, we'll look at "tracking error" and why I believe it holds much less significance than many believe. 

Tracking Error

Investopedia.com defines tracking error as, "A divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark." Tracking error is frequently used to measure the degree to which a particular mutual fund strays from its peer group. Its proponents believe that a fund should stay true to its peers, and hence, have a low tracking error. In the past I would have agreed. 

However, when things get bad and the bottom is falling out of the financial markets, I would prefer to have managers  who have the ability to increase their allocation to cash to avoid a large loss. There are a few funds that did this in 2008 to help protect shareholders. However, because of this flexibility, they also have a higher tracking error. Hence, my point that tracking error may not be that significant. 

Tracking Error and Index Investing

Tracking error is somewhat related to index investing as an index is often used as a benchmark when calculating a given fund’s tracking error. Moreover, the goal of "passive" investing is to mimic the returns of an index, minus fees. Many mutual fund managers are "graded" based on how they perform relative to a particular benchmark. In an attempt to exceed the benchmark, fund managers will often increase the risk in their funds. However, if a fund manager is simply trying to keep pace with an index, then it might be better to buy a lower-cost index fund. 

Moreover, if an investor doesn't mind running with the "herd" then an index fund may be appropriate. This is because an index fund tracks with a large universe and as a result, a few hot stocks will have a lesser impact on total return. 

Does Index Investing Carry Greater Risk?

There is an inherent problem with passive investing related to the index chosen. For example, during the meteoric rise in the 1990s, the S&P 500 Index became very tech heavy as technology stocks outperformed. By the time the tech bubble burst, technology was such a large component that when it did crach, the S&P fell hard. Therefore, a cap-weighted index such as the S&P 500 may not be in the best interests of the investor, especially on the way down. 

Thanks for reading and have a great week!

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