The fund’s tracking error and operating expenses are two factors that can affect the fund’s performance and its attractiveness as an investment over time, either on its own, or in the context of a larger portfolio of funds, S&P said in a release on its Web service Fund Advisor.
Tracking error measures the difference between an index fund’s return and the benchmark’s return over a given period. A low tracking error typically implies that the fund is successful in keeping pace with its benchmark index, where tracking error is inflated by a number of factors that include:
- fund expenses and transaction costs
- cash balances to meet redemptions
- mechanics and difficulties of trying to match the fund’s holdings to the index.
The trading strategies and portfolio construction of an index fund can either minimize or maximize tracking error between the fund’s portfolio and the benchmark index. Take two models for consideration. In the first model, a fund may be attempting to fully replicate the index by purchasing all of its securities in the correct weightings, thereby trying as close as possible to replicate the fund’s underlying benchmark and aiming for a low tracking error. The second model is simply a representative sample of the stocks in the index and is not likely to track the fund’s underlying benchmark index as closely typically.
“While there may not be enough of a material difference among tracking errors for the majority of S&P 500 index funds to cause real concern among retail investors, it is something investors need to be aware of in the final analysis,” noted Standard & Poor’s Managing Director of Funds Research, Phil Edwards in a statement. “Investors buying index portfolios for the long haul, however, would want to look closely at an index fund’s expense ratio, as well as its tracking error.”
Fund Advisor identified 65 index funds out of a universe of 72 tracked in its database, which invest in the S&P 500 and have at least three years of operating history. Among the top performers:
- Dreyfus Index Funds: S&P 500 Index Fund (0.06%)
- Dreyfus BASIC S&P 500 Stock Index Fund (0.07%)
- Vanguard 500 Index/Inv (0.08%)
- Munder Funds Index 500/A (0.08%)
- One Group Equity Index/A (0.08%).
On the other hand, the funds with the highest tracking errors were:
- Scudder Select 500 Fund/S – now closed to investors – (2.31%)
- ProFunds: Bull ProFund/Inv (0.95%)
- Principal Large Cap Stock Index/B (0.63%)
- California Investment: S&P 500 Index Fund (0.42%)
- ARK Funds: Equity Index Fund/A (0.40%).
All things being equal, higher expense ratios on index funds can eat into their performance, consequently affecting tracking error. Those expenses can translate into large differences in an investor’s real returns over time. The higher the expense ratio on nearly identical portfolios, the lower the real return.
Similar to tracking error, Fund Advisor identified the funds with the highest and lowest expense ratios. Among the funds on the bottom end:
- United Association S&P 500 Index Fund/II (0.12%)
- SSgA S&P 500 Index Fund (0.16%)
- Vanguard Tax Managed Growth & Income (0.17%)
- Vanguard 500 Index/Inv (0.18%)
- Schwab Capital Trust S&P 500 Fund/Select (0.19%)
Conversely, the index funds with the highest expense ratio were:
- ProFunds: Bull ProFund (2.94%)
- ProFunds: Bull ProFund/Inv (1.85%)
- Advantus Index 500 Fund/C (1.60%)
- BlackRock Index Equity Fund/Inv C (1.53%)
- Mason Street Funds Index 500 Stock Fund/B (1.50%).