Investors will often want to know how closely the returns from a fund or portfolio follow a benchmark index (such as the FTSE 100 or the S&P 500). In some cases, they want to make sure that an index fund is matching its benchmark. Alternatively, they may want to check that the manager of an actively managed fund is trying to run the fund in a way that can produce returns that are different from the benchmark, rather than following it too closely (known as index hugging or closet tracking).
Tracking difference is one way to look at this. It refers to the difference between the return on the index and the return of the fund over a set period of time. So if an index rises 7% and the fund gains 6%, the tracking difference is -1%.
For an index fund, we want this to be consistently as small as possible. It will usually be negative because the costs of running a fund mean that it cannot quite match the return from the index. However, there are various factors that can offset costs and might even produce a small positive tracking difference – these include income from securities lending (helping offset running costs) and differences in taxes on dividend taxes (the fund manager may be able to structure the fund to pay less tax than the full rate assumed by the index compiler).
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In an active fund, tracking difference is referred to as active return. You want this to be positive over the long term. If not, you’d have done better buying an index fund.
The volatility of the fund’s tracking difference is known as the tracking error. An index fund should have a tracking error close to zero. Active funds may have low or high tracking error – this depends on the approach they follow and doesn’t by itself tell you if the manager is good. But the information ratio – the active return divided by the tracking error – is one way to assess how much value the manager has added relative to how much they deviated from the index.
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