Oranges and Apple

Index Tracking is a Secondary Goal

Oranges and Apple

As investors examine year-end performances of their index funds, one measure they should not focus on too closely is tracking error. Keeping a portfolio reasonably close to its intended index is desirable, but experts caution against zealous efforts to mimic indexes perfectly.

"Zero tracking error strategies make almost no sense," said Diane Garnick, Global Investment Strategist of State Street Global Advisors, before an audience of pension plan managers at the recent Super Bowl of Indexing in Phoenix. Rebalancing entails buying and selling of securities, and this brings explicit (broker fees) and implicit (bid/ask spread) costs.

These costs occur each time a security is added or removed from the S&P 500 and each time a small firm grows in or out of inclusion in typically volatile small capitalization indexes. Style drift and other factors come into play in complex ways. "I don't think a lot of people have stopped and thought hard about the implicit costs of zero tracking error," said Garnick.

For individual investors the issue is no less pressing. Recently a discussion board thread between investor George J, top financial advisor Larry Swedroe and others addressed key points.

When reasonably close tracking occurs investors are comforted by knowing that capital is deployed toward desired assets. At times, however, the cost to do so means that sometimes it is wisest to be passive and make infrequent changes to a portfolio. We do not live in a perfect world where action is always rewarded. Sometimes inaction is rewarded more.