Why your tracker fund didn’t match the benchmark

Passive funds are designed to replicate a specific part of the market, mimicking the stock weightings and exposure in a cheap, useful package. Why then do some make better returns than the market, and many actually make less?

Tracker funds or ETFs are some of the most popular products for stock market exposure because you can get a lot for your money.

How does your tracker fund stack up?

Take the iShares Core MSCI World UCITS ETF or the Vanguard S&P 500 UCITS ETF (Dist), which are two of the most popular options among AJ Bell DIY investors, tracking the main global and US equity indices, respectively. For minimal charges, you can get access to hundreds of the world’s most well-known publicly listed companies.

AJ Bell has previously gone in depth to examine the most popular global and US passive funds and the differences between them, including these two products.

Because passives work by taking a blanket approach to whichever index they are following, you’d expect them to make pretty much the same returns as the benchmark. However, this isn’t necessarily the case.

The iShares fund made 11.16% in the first six months of the year, while the MSCI World index made 11.17%, according to data from FE Analytics.

Over five years the Vanguard fund actually made a higher return than the index, 92.57%, while the S&P 500 made 91.05%. This outperformance pattern repeats over three years and shorter time frames within the past 12 months. This reflects currency movements, something we will explain in fuller detail later in this article, because this vehicle is denominated in sterling.

While the total return disparity isn’t huge, it highlights a phenomenon called ‘tracking error’. Tracking error isn’t specific to just these funds highlighted above; it’s a characteristic of all passive products and ideally you would want it to be as small as possible.

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Research by Morningstar in 2013 summarised it as follows: “ETFs are designed to track the performance of an index. While this concept is easy to understand, putting it into practice is far more difficult than it seems. While indices are typically replicable in theory, index returns are an unattainable ideal, as they ignore the practicalities of portfolio construction and ongoing management.”

They added “investors need to be aware of these realities and manage their expectations accordingly. There will always be factors involved in the replication process that will cause mistracking”.

The main reasons this return disparity occurs are:

• Fees
• Replication methods  
• Currency  

Fees

As noted by Morningstar, indices are perfectly replicable in theory only. It’s true that an S&P 500 ETF can have the exact same holdings as the S&P 500 with the exact same weightings but building and running that has costs that aren’t reflected in the performance of the index.

Although passive funds are cheaper to run than an actively managed fund, they still cost something to maintain and build, like when changes are made to the index, stocks either joining or leaving in rebalances, the provider of a tracker fund has to recalibrate it to make sure it still matches up.  

In short, funds have fees and indices don’t, which feeds into the disparity in returns.

Replication  

So far, the premise has been that a tracker fund seeks to perfectly replicate the underlying benchmark. But there is a second way index funds can be built which involves tracking most, but not all, of the benchmark.

This is called ‘index sampling’ a practice where a fund doesn’t seek to perfectly replicate the make-up of the underlying benchmark but instead builds a portfolio that represents the index’s broader risk/return profile, while still trying to match the index’s return levels.

A study in 2022 between Cornell and Brigham Young Universities looked at the differing outcomes between equity index funds which took the exact replication method and the ones which followed this representative sampling.

The researchers found that funds might look to hold only the biggest stocks in the index that it’s tracking, with the idea that these companies make up the majority of the returns anyway and holding less names means they can avoid the more illiquid members of the market.

Is your ETF actually that cheap?

They found that the sampling method had to trade three to four times more often than the ‘true replica’ fund, which incurred higher expenses and fees, which feeds into the first factor.

The research also found that the sampled funds underperformed not just due to this racking up of higher fees, but oxymoronically “also poor stock picking”.

There’s a separate way some ETFs look to match the performance of an index, known as synthetic or swap-based replication.

Synthetic ETFs use financial contracts – called swaps – which it agrees with a third party, usually an investment bank, whereby the latter pays the fund the return of that index.

Investors should get the performance of the market being tracked, but the fund gets there through a financial agreement rather than by physically holding the underlying shares, which should mean low tracking error overall. Unlike the other methods though this introduces counterparty risk, i.e. the bank could fail or default.

Currency

Sticking with the example of buying an S&P 500 tracker fund as a UK based investor, while this is a market which feels very familiar to us, it’s still an overseas market and the companies in it trade in US dollars rather than sterling.

Currency rates can impact both your passive and active returns because foreign exchange rates – the value of one currency versus another – fluctuate daily.

Just like when you go to the airport and get a good or bad start to your holiday depending on how many euros, Swiss francs or yen we get to spend, the same calculations happen in your funds. Or as is true Brit math's, how many pounds does a beer cost there?  

When you invest overseas, the price of your investments will be in the local currency, and you must convert your earnings back into pounds.

An example of when this worked out well for sterling-based investors was in 2016 when the pound tumbled versus the dollar in the wake of the Brexit vote. The S&P 500 rose 9.5% in dollar terms for the year but UK investors earned close to 31%, data from Vanguard showed.  

But this can swing the other way, as when the dollar weakened last year after US President Donald Trump’s ‘Liberation Day’ tariffs hit the S&P 500 in US dollar terms was up 6.2% by the end of June, but down in sterling.

In the table above you’ll notice that there are two S&P 500 indices there, one rebased in sterling and the other US dollar. As you can see, the total returns are similar, but not identical, demonstrating this currency effect.  

This can feel very technical and you might think you already have enough to consider when it comes to investing without bringing in the currency, but it is important to note or at least, understand if your passive fund’s returns seem off versus the underlying benchmark.

As stated up top, tracking error on a passive fund tends to be fairly minimal, but it’s something worth checking out and comparing before making an investment. It can also be a good way to spot if something isn’t as you’d want it under the bonnet of a tracker.