#tracking error

There are many stock market indices, but the best known in the UK is the FTSE 100.  This looks at share price movements for the 100 largest (by stock market capitalisation) UK companies .  Suppose that, on average, these share prices move up overall by 1% over the course of a day.  In that case, the FTSE 100 Index would also rise by 1%, e.g. if it were 6500 yesterday, it would rise to 6565.

Each of the 100 companies should also pay a dividend to shareholders, hence the pure index performance as above would be increased to allow for this.  If an investment fund were to buy and sell stocks with the sole objective of matching the index (or average holding), it would achieve a performance equal to the index increased to allow for reinvested income.

There is also an annual management charge typically in the range of (say) 0.5% per annum to 1% per annum.  An index tracking fund has no ambition to beat the index.  It should simply produce a rate of return equal to the index performance plus an allowance for reinvested income minus an allowance for the annual management charge.  Any deviation whether positive or negative is known as a tracking error.

The alternative and traditional investment approach is known as active management.  An active investment manager takes a view as to which shares to buy, hold and sell and hence achieves a performance which is hopefully better than the index or average return.  However, an active manager’s expenses will be higher and this is often reflected by a higher annual management charge.

Part 2 of this short series will explain how to choose between index tracking and actively managed funds.