As an index manager, one of our key roles is to try to track the index as closely as possible. It’s harder than you’d think. There are a number of reasons why we can’t do exactly what the index does, at the time and price it takes. As a result, we put a lot of energy into our efficiency, and there are even occasionally opportunities to do better than the index, which is not down to chance.
What is tracking?
There are two measures of “tracking” which show the outcome of these efforts; tracking error and tracking difference.
Tracking error is the difference between the movement of the index and movement of the fund on a daily basis, and the standard deviation of those movements. For example, our NZ 20 Fund tracking error is currently 0.03%. We will start to publish these numbers after we have a year’s worth of performance next month.
The second and more important measure for an investor is tracking difference. Tracking difference is simply the difference between the fund performance and the index performance over a period of time for a fixed amount (e.g. $1).
There is gross tracking difference (before fees) and net tracking difference (after fees). We report the fund and index performance on our website and the difference is the net tracking difference.
Currently, Kernel’s net tracking difference for 1 January to 31 July 2020 is:
|Fund||Net tracking difference|
|NZ 20 Fund||+0.09%|
|NZ Commercial Property Fund||-0.08%|
|NZ Small & Mid Cap Opportunities Fund||+0.10%|
What this means for you as an investor is, if you had invested in the NZ 20 Fund on the 1st of January, your investment return as at 31 July would have been 5.39% and this would be 0.09% more than the index return after fees.
Why is this important?
Normally you expect an index fund manager to underperform by at least the amount of management fees, so in our case approx -0.23% for these seven months. Next month we will start to explain some of the factors how Kernel can do better than the index through our market leading operations and dedicated focus on our investors’ net returns.
Meanwhile, you can do the same comparison for any active fund using the standardised Fund Updates. This is because an active fund manager’s tracking difference is called their Alpha. Gross Alpha – before fees, and Net Alpha – after fees. Every manager promotes their expertise to do better than the index, and so few actually do.
To check how your fund manager (whether passive or active!) is doing find the latest quarterly Fund Update from the fund manager’s website (they legally have to publish these).
Then look for the box showing:
|Annual return |
(after deductions for charges and tax)
|Annual return |
(after deductions for charges but before tax)
|Market index annual return |
(reflects no deduction for charges and tax)
In this example our hypothetical Fund produced 14.44% return after fees. Great! Happy days.
However, its tracking difference or alpha was -1.28% (i.e. the market index return minus 14.44%).
Not so great, as a significant underperformance.
The second thing to check is which market index or benchmark is used. Often this is in a footnote, but it will definitely be in the Fund’s published SIPO.
Sometimes sneakily, the Fund has chosen the cash rate or an obscure benchmark, rather than a global or country specific benchmark to compare itself to. We would recommend using the S&P/NZX 20 Index as a comparison for any New Zealand equity fund.