Is tracking an index worth the cost?

You may see traditional index funds and ETFs as efficient vehicles for gaining diversified exposure to specific asset classes. But are indices precise representations of the underlying asset class? If not, it may not be worth incurring the cost of tracking them perfectly.

The proliferation of index vendors has resulted in many indices for the same or similar asset classes, each with slightly different definitions and reconstitution (or rebalancing) schedules.

This results in variations in the annualized performances of the various indices, as well as high tracking errors (a measure of index performance compared with the benchmark). This dispersion in index returns stems from small differences in security weights, a result of subtle differences in methodology and reconstitution dates.

Random performance fluctuations

The construction rules governing various indices aren’t any sort of forecasting or timing ability intended to improve returns. So when one index outperforms the others in the same asset class over a month, year or longer, the result is likely period-specific and purely random.

The differences in performance can be large and would make many investors uneasy. Over time, the winners and losers tend to swap places.

What are the costs?

Since each index targets the desired asset class in a similar fashion, with no evident expected return benefit attached to choosing one over another, picking an index to track is likely to be subjective. Where does this leave you, the investor, as you try to capture the return of a specific asset class?

The arbitrary nature of this decision, and the fact that selecting any specific index will produce tracking error relative to the others, suggests trying to achieve perfect replication should not be an objective. In fact, there is a high cost to near-perfect tracking.

These costs are incurred in many ways. For instance, when stocks in an index change, managers may have to trade them within a narrow period. Trading during such periods can be especially disadvantageous. The manager may have to accept a lower selling price, since all managers tracking that particular index are trading the same securities in the same direction at effectively the same time.

A more subtle cost is potential style drift. Indices are reconstituted or rebalanced periodically, but stock prices constantly change. In the months or weeks between reconstitutions, an index may include securities that have experienced significant price movements and no longer belong in the index based on its own specification and methodology.

Despite the continuous changes occurring in the market, index fund managers seeking to minimize tracking error must hang on to (and invest new money from cash flows into) securities that have migrated out of the index until the next reconstitution date. This constraint can cause meaningful style drift.

The objective of all of these factors — no rebalancing for months, reinvestment of cash flows in the original set of securities at specific weights, and synchronized rebalancing across managers at specific dates — is to achieve a daily return as close as possible to the published return of the chosen index.

But how does this fit with the original objective of earning the return of the desired asset class in the most efficient manner possible? Are these two objectives compatible? Early on, indices were benchmarks for evaluating a fund manager’s risk-adjusted performance. But the use of indices has shifted. In some cases, managers are letting the arbitrary composition of a commercial benchmark drive their investment strategies.

A superior investment approach should offer consistent and diversified exposure to an asset class without incurring the potentially high cost of trading.

By removing the low tracking error requirement, this type of strategy could effectively avoid trading during reconstitution periods and focus on capturing the returns of the broad asset class. In fact, by allowing some tracking error and diversifying across many names, managers could reduce costs and even seek out opportunities to add value by providing liquidity to the indexers who are forced to trade during the narrow time window of reconstitution. Focusing on reducing tracking error can be costly, and there’s no evidence that incurring those costs has meaningful benefits.