Tracking difference

What tracking difference means

Tracking difference is the gap between the return of a fund and the return of the index it is meant to follow, measured over the same period. If an index gains 8.00% in a year and the fund that follows it gains 7.70%, the tracking difference is minus 0.30 percentage points. A negative number means the fund lagged its benchmark. A positive number means it did slightly better.

The term mostly appears in the factsheets and annual reports of index funds and exchange-traded funds (ETFs), and in comparison tables on broker and fund-research sites. Investors use it to answer a simple question: if I buy this fund to get the index return, how much of that return do I actually receive? It is a result measured after the fact, not a promise about the future.

Tracking difference is often confused with tracking error. They are related but not the same. Tracking difference is the net gap in return over a period, with a sign. Tracking error is the volatility of the daily or monthly gaps, usually shown as an annualised standard deviation. A fund can have a small tracking difference over a year and still wobble noticeably around the index along the way.

How it works

A fund's published return is calculated after costs. The index, however, is a theoretical calculation with no costs at all. Several things therefore pull the fund away from the index.

• Ongoing charges. The management fee and other running costs are deducted from fund assets every day. This is usually the biggest and most predictable part of the gap. See expense ratio.
• Trading costs. When the index changes its constituents or the fund receives new money or redemptions, the manager has to trade, paying spreads, commissions and sometimes taxes.
• Sampling. Some funds hold only a representative subset of the index rather than every stock. That saves cost on hard-to-trade markets but adds a small deviation.
• Cash drag. Cash held for redemptions or waiting to be invested earns different returns than the index assets.
• Withholding tax on dividends. Foreign dividends may be taxed at source at a rate that the index calculation does not assume, which depends on the fund domicile and treaties.
• Securities lending income and other offsets. Lending out shares to short sellers can earn income that partly or fully offsets costs, and this is why some funds show a tracking difference smaller than their stated fee, or even positive.
• Pricing and currency effects. Differences between the time the index and the fund are priced, or in how currency conversion is applied, add noise.

The calculation is plain arithmetic. Tracking difference = fund return minus index return, both over the same dates and on the same basis (for example both total return with dividends reinvested, or both in the same currency). Comparing a fund's total return to a price-only index would produce a misleading gap that is mostly just dividends.

A worked example

These numbers are illustrative only. Suppose a fund follows a broad equity index, and over one calendar year the index total return was 10.40%.

1. Fund management fee deducted over the year, about 0.20%.
2. Trading costs and cash drag, about 0.06%.
3. Extra dividend withholding tax versus the index assumption, about 0.10%.
4. Income from securities lending credited to the fund, about plus 0.07%.

Net effect on the fund = minus 0.20 minus 0.06 minus 0.10 plus 0.07 = minus 0.29 percentage points. The fund therefore returned roughly 10.40% minus 0.29%, which is about 10.11%.

Tracking difference for the year = 10.11% minus 10.40% = minus 0.29 percentage points. On an investment of 20,000 EUR, that is about 58 EUR less than the index would have produced, ignoring your own broker's dealing costs.

Why it matters

Small gaps compound. A shortfall of 0.30 points a year looks trivial, but over 20 years on a growing balance it can reduce the final amount by several percent. Because the cost shows up in the fund price rather than as a separate invoice, many investors never notice it unless they compare it with the index.

Tracking difference is also a better test of real cost than the headline fee. A fund with a 0.25% fee that lends securities efficiently may trail the index by less than a fund with a 0.15% fee that is poorly run. Two ETFs on the same index can therefore deliver different outcomes, and the cheaper-looking one is not always the better one.

For people who buy ETFs through a broker, there is a second layer. Tracking difference measures the fund. Your own cost of owning it also includes the broker's commission, the bid-ask spread when you buy and sell, and any currency conversion fee. These are separate from the fund's figure.

How to use it in practice

1. Find the figure in the fund's annual report, key information document or the issuer's website. Look for several periods such as one, three and five years, not just the latest year.
2. Check that the fund return and the index return use the same basis, usually net total return after the fund's applicable withholding tax and in the same currency.
3. Compare tracking difference with the ongoing charge. If the gap is much bigger than the fee, find out why, for example sampling, tax leakage or a swap structure.
4. Compare at least two funds on the same index, using the same time window.
5. Look at the consistency of the difference across years. A steady small gap is easier to plan around than an erratic one.
6. Add your own broker costs and spread before deciding which product is cheaper for you in practice.

Common mistakes and misconceptions

• Treating a low fee as proof of low tracking difference. The fee is only one component. Taxes, trading and structure also matter.
• Mixing up tracking difference and tracking error. One is the net return gap, the other measures how bumpy the gaps are.
• Comparing a fund's total return with a price-only index. The result will exaggerate the lag because dividends are missing from one side.
• Using one year of data. A single year can be flattered or hurt by a one-off event such as a tax change. Longer windows give a better picture.
• Assuming past tracking difference will repeat. Fees, tax rules and securities-lending arrangements can change.
• Expecting it to be zero. Some shortfall is normal for any fund that has costs.

Risks and limitations

Tracking difference describes history. It does not tell you what the index itself will do, and a fund that follows its index very closely will still fall when the index falls. Capital invested in funds can lose value.

The figure also depends on how it is reported. Issuers may compute it gross or net of tax, against different index versions, or for different share classes, so numbers are not always directly comparable. Leveraged and inverse funds, which reset daily, are a special case and usually deviate sharply from the index over longer periods, so the concept needs careful reading there. Finally, tracking difference says nothing about the fund's counterparty, structure or liquidity risks.

How Brokeli looks at it

When we review brokers that offer ETFs and funds, tracking difference is a useful way to separate the cost of the product from the cost of the platform. Our research snapshots focus on what the broker controls, such as commissions, spreads, currency conversion and custody charges, and we point to fund documents for the product-level figures. Looking at both together gives a fuller picture of what an index exposure really costs.