You will be able to measure how far an ETF's return fell short of or beat its index.
Two ETFs track the same all-world index. Fund A has a TER of 0.15% and Fund B 0.22%, both made-up figures. Farhan, fresh from lesson 3.1, Expense ratio and the costs it leaves out, assumes A must give him the better result. Then he reads both annual reports and finds that over five years, B has stayed closer to the index than A. The fee table was telling him something true, and something incomplete.
What you really want to know about an index fund is how much of the index's return reached you. That number has a name.
Tracking difference is the fund's return minus the index's return over the same period, usually a calendar year. If the index returned 10.3% and the fund returned 10.1%, the tracking difference is minus 0.2 percentage points. That gap is what you lost, inside the fund, compared with holding the index itself at no cost.
Most of the time tracking difference is negative, because the fund pays costs that the index does not. Sometimes it is positive, and the fund beats its own index for a year. That is not a mistake in the data. It comes from the items in the next section.
One detail matters when you compare. Index providers publish more than one version of an index's return. A net return version deducts a standard rate of withholding tax on dividends, and that is usually the version funds measure themselves against. Use the index return the fund's own documents name, so you are comparing like with like.
The TER is one of the things that pull a fund's return below its index. It is not the only one, and some things push the other way.
Trading costs pull the return down. Whenever the index changes its members, or money flows in and out, the fund buys and sells shares and pays commissions and spreads that the index ignores. Cash drag pulls it down too: a fund usually holds a little cash, which earns less than shares in a rising market.
Taxes can go either way. If the fund pays more withholding tax on dividends than the index assumes, it falls behind. If it pays less, because of the country it is set up in or the treaties it can use, it gains. Lesson 3.3 explains why that happens.
Securities lending can push the return up. Many funds lend some of their shares to other market participants for a fee, and part of that income goes back into the fund. The fund's documents say whether it lends and how the income is split, and lending comes with its own small risks, which the documents also describe.
Put together, these explain how Fund B, with the higher TER, can still trail the index by less than Fund A.
Tracking error sounds similar and measures something else. It is how much the yearly gap varies, usually expressed as a standard deviation. A fund that trails its index by exactly 0.2 points every year has a tracking error close to zero, even though it loses 0.2 points a year.
For a long-term holder, the average gap is what you pay. The wobble around it matters less, because the ups and downs tend to cancel out over many years. Funds often show tracking error prominently on factsheets, so make sure you know which one you are reading.
Here are made-up figures for five years. The index returned 10.3%, minus 18.2%, 22.3%, 7.7% and 15.1%. Fund A returned 10.1%, minus 18.4%, 22.0%, 7.6% and 14.9%. Its tracking differences were minus 0.2, minus 0.2, minus 0.3, minus 0.1 and minus 0.2, which average minus 0.20 points a year.
Fund B returned 10.4%, minus 18.9%, 22.6%, 7.1% and 15.2%. Its tracking differences were plus 0.1, minus 0.7, plus 0.3, minus 0.6 and plus 0.1, which average minus 0.16 points a year. B is the noisier fund, with a much higher tracking error, yet over the five years it kept more of the index's return.
Now notice what one year would have told you. Judged on the second year alone, B looks far worse than A. Judged on the third, B beat its index outright. Neither single year gives you the real picture. Use as many years as the fund has published, from the annual report or the factsheet's performance table, and note any year where something unusual happened, such as a change of index.
There is one more trap. A fund younger than three or four years does not have enough history for a fair average. For a new fund, the TER is your best guide until its record builds up.
The activity puts two real funds through the same arithmetic: list the yearly returns, subtract, add up and divide. Pick two funds you would genuinely consider, so the answer feeds into your comparison sheet in lesson 3.5.
For two ETFs on the same index, record the yearly fund and index returns for as many years as published and calculate the average tracking difference.
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