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How good is your index tracker at tracking its index?

Stanlib comes out tops.

CAPE TOWN – When discussing the merits of passive fund management, investors generally accept that passive investing will do what it says on the box: it will give the return of the index.

However, this is not strictly true. For a start, passive funds will, at best, give you the return of the index minus whatever fees they charge.

Secondly, and more importantly though, all index funds have some degree of tracking error. In other words, they will naturally show a slightly different performance to the index itself, because it is impossible to replicate any index exactly.

Often the advice one gets around passive funds that track the same index is to just buy the cheapest one. After all, they should all be providing the same return, so it makes sense to get the one that comes at the lowest cost.

But tracking error should not be discounted. It can have a material impact.

Running a passive fund might sound simple, but it is really quite complex in practice. Some very clever strategies are required because with money coming into and leaving the fund at any time, market movements and dividends being paid out and reinvested, it is very difficult to mirror the index at all times.

In theory, whenever you put money into an index fund, the fund manager takes your money and buys the shares in the index in exact proportions. But of course, this isn’t what happens in practice.

If you invest R300 into a Top 40 exchange-traded fund (ETF), for instance, that isn’t even enough to buy a single share in BHP Billiton, so there’s no way you can get all 40 shares for that. Similarly, if you sell R1 000 worth of the same fund, you’re not selling one of every share, because just one Naspers share is worth more.

Another challenge that passive fund managers face is dealing with changes in the index constituents. Funds have to be very careful about how they respond to this, because they will always be doing so retroactively. They need to buy and sell different shares to get their holdings back into balance, and that may mean that some value is lost.

It is also possible that certain stocks appear in an index, but are difficult to include in in a tracker fund in exactly the same ratio. This is either because of liquidity or because the shares just aren’t easy to get hold of.

A good local example might be Kumba Iron Ore, which does not have a very large free float of traded shares, as Anglo American and the Public Investment Corporation own more than three quarters of the company between them. As there is not much left over for everyone else, passive funds often hold Kumba in lower proportions than its real index weighting.

Passive fund managers employ sophisticated software to manage all of these complexities, and to decide where to sell and where to buy. They try to do this without distorting the prices of the shares being bought and sold while at the same time keeping the portfolio holdings as close to the index as possible.

They all use different strategies for this, and the truth is that some end up doing it better than others. This comes down to the timing of trades, when dividends are re-invested and the fact that passive funds have to keep some cash on hand for liquidity, which creates a natural drag.

It is also possible that tracking error can be on the up-side. In other words a fund may return more than its index due to the strategies it has used, but this is less common.

Investors should appreciate that this is a part of index tracking, but that shouldn’t mean that they simply accept it. Because the differences in tracking error between funds can be significant. So it’s worth being aware of how different funds stack up.

The difficulty that investors have however, is that not all fund report their tracking error. So you may need to take a bit of time to work it out for yourself.

The below table looks at the seven local products that track the FTSE/JSE Top 40 Index that have been around for longer than one year. They include four unit trusts and three 3 ETFs.

It shows their relative one year performance to 30 June 2014, illustrating how far they deviated from the index. It then removes the total expense ratio from that deviation to reveal what portion of it is cost and what is tracking error.

Note that there may still be other costs that are not reflected in the TER which impacted on performance, but this is the closest estimation to tracking error one can get. Also, the Investec Top 40 ETN was not included in this list as it does not have a published TER.


Top 40 Index Funds to 30 June 2014


1 Year total return

Deviation from index


Tracking error

FTSE/JSE Top 40 Index





Kagiso Top 40 Tracker Fund





Old Mutual Top 40 Fund





Stanlib Alsi 40 Fund





Momentum Top 40 Fund





RMB Top 40 ETF





Satrix 40 ETF





Stanlib Top 40 ETF





Sources: Fund fact sheets

This analysis shows that Stanlib has the best record over the last year. It’s unit trust shows a tracking error of only seven basis points, and its ETF no error at all.

The RMB Top 40 ETF has the fourth lowest tracking error, but the second lowest overall deviation from the index. This is due to its very low TER.

The Old Mutual Top 40 unit trust stands out on the other end of the scale as having the largest tracking error. Since it also already comes at the highest TER, it would appear to be the least appealing of these funds.


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