I was studying two index funds that are tracking the same index. Both have similar returns for 3 year and 5 year. However Fund X has 'low expense ratio' and 'high tracking error' whereas Fund Y has 'high expense ratio' and 'low tracking error'.
How can I quantitatively find which one is the better one?
Please help.
Hi Ganesh,
Logically speaking, you would like to invest in an index fund that has a low expense ratio as well as a low tracking error. If both the parameters are in the same units (annualised for example), then you can simply multiply the tracking error by the expense ratio and select the fund with the lower result.
Hope this helps.
Hi Rekhit,
This should be helfpful. Thanks a lot.
Let's get some jargons sorted. Usually tracking difference is the term used for expressing the difference in returns between the benchmark and the index funds. Tracking error is usally used to signify the volatility of this tracking difference. (But sometime tracking error is also used to imply tracking difference.) Let's rephrase your question to 'which fund is better, one with higher expense ratio or higher tracking difference (in the sense above)'. Usually tracking difference is computed based on total returns of the funds. This also include the expenses. You need to double check for the funds if that is the case for reported numbers. In that case, tracking difference D = E + X, where E is the expense component, and X is other sources of errors. So it does not make sense to compare E+X of one fund with E of another. For investors' point of view, D is the relevant number. Compare the tracking difference of both funds (assuming they are stable). Comparing the combined metrics D makes more sense if you consider the other possible sources X. For a fund, it is cheaper to try to replicate a benchmark with fewer components. This drives down E, but this may have a negative impact on the total number D.
To summarise, in most cases, expense ratio and tracking difference is not one-to-one comparable. Use tracking difference (assuming it includes the expense component) and its stability to make your choice.
Hi Prodipta,
Thank you for answering.
Can you please provide some article or study regarding this so that I can understand this concept in detail?