Passive Funds and ETFs are hugely more popular these days than in the past. People believe that markets in efficient and that news about a company is quickly reflected in its share price, whether the news is good or bad. When investing in a passive fund, although the fund manager doesn’t have to make any active decisions on what stock to buy, they do have to try to get as close to the index they are tracking as possible.
All funds, whether they are passive or active, track a benchmark in some form or the other. In the case of an active fund manager, they will try to beat the benchmark (they usually fail over the long term). For a passive fund manager, their goal is to match the benchmark exactly. The difference between their returns and the actual return achieved by their benchmark is the tracking error.
I looked at the big three Index Fund providers, Blackrock, State Street and Vanguard. Their Global Equity fund all tracks the MSCI World Index. That is an index tracking a number of companies from around the world excluding emerging markets.
For comparison purposes, I also looked at Irish Life’s Global Indexed Fund. Their benchmark is the average weighting of shares within Irish managed pension funds, with a limit on Irish shares (if there is a limit on Irish shares, they are making an active decision on what stocks to buy, so you could argue that this isn’t a passive fund).
I then looked at the returns that each fund produced over the last 5 years compared to their benchmark:
If you invested €10,000, how close would these providers have actually been to matching the benchmark?
So State Street are the most accurate in this example, only being the smallest of fractions away from perfection. Vanguard were surprisingly a fair amount out but still not that much to be worried about.
Next, I looked at Irish Life’s performance compared to their benchmark (I didn’t track the MSCI as that’s not the index they track).
Same again, if I invested €10,000 in 2013, what would it be worth at the end of 2017?
In this example, you would have 8.3% or €1,564 less in your fund over 5 years. That is a huge difference. What it is telling me is that they are either not very good at tracking the index or they are actively managing the fund.
So before you go investing your money in passive funds, make sure they are actually doing what they said they would.
If you have any questions, you can email me at firstname.lastname@example.org