In this hectic time that has been 2022, passive investing has increasingly become the new black. Passive investing typically means replicating the performance (or holdings) of a particular benchmark/index or a combination. In this regard, it might raise some confusion when investors see their investment (ETF or mutual fund) perform slightly differently from the index or benchmark the investment is supposed to replicate. This difference is known as tracking error (error tracking the benchmark, easy enough?). In this blog, we shall outline the causes of tracking errors:

1. Fees charged: ETFs and mutual funds typically have annual fees attached to them. Some funds may even eliminate fees for a certain period of time just to attract more investment. Management fees charged eat into overall performance.
2. Trading commissions and taxes: Indices are paper-based or hypothetical portfolios with no trading costs or taxes. While some brokerages may offer free trading on some instruments, for Canadians, we do not have many options other than paying trading commissions and taxes.
3. Number of securities: For many large indices, changes in the holdings are known ahead of time to maintain transparency and easy replication. However, they do come at a cost to the ETF or mutual fund. The higher the number of securities, the higher the trading costs, and the more work it takes to maintain replication (especially if some securities are relatively illiquid). Frequently, ETFs or mutual funds intend to replicate the performance of a select index via sampling, i.e. select a subset of the total index. In that case too, the higher the number of securities, the higher the performance of the investment deviates from the intended index.
4. Intra-day trading: Benchmark holdings are “bought-and-sold” are end of market close prices, while the funds that replicate them have to purchase or sell securities during the trading period. This can lead to a difference in initial purchase/sell price when calculating returns for the fund and the benchmark.

*Index and benchmark have been used interchangeably in this blog.

While this may seem a lot, most large index-based ETFs and mutual funds have minimal tracking errors given certain requirements of indices. For example, an index must be replicable, transparent, and have a methodology clearly stated. Additionally, in competition for low fees, tracking errors have cut down considerably, while computer algorithms ensure proper or close to accurate replication.

All the best!