When Tracking Error Is a Fix, Not an Error
Tracking error is typically measured between an investment strategy and a benchmark index. But benchmark indices have tracking error among themselves. Within US small cap stocks, for example, return dispersion over 12-month periods has exceeded ten percentage points between certain index pairs.
If tracking error is inevitable, why not use it to fix the potential shortcomings of indexing and meaningfully increase expected returns? Broad market and small cap index funds often hold small cap stocks with low profitability1 or high asset growth2, which are segments shown by research to underperform the market.3 Excluding these stocks boosts expected returns in exchange for tracking error. That seems a reasonable tradeoff in the context of what index funds are already incurring relative to one another. After all, we rarely mourn the difference in mineral concentration between regular tap water and delicious filtered water.
The sample period shown reflects a common period for which data is available for all indices presented.
Past performance is not a guarantee of future results. All indices are gross dividends.
Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. MSCI data © MSCI 2023, all rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Dow Jones and S&P data © 2023 S&P Dow Jones Indices LLC, a division of S&P Global. CRSP data provided by the Center for Research in Security Prices, University of Chicago.
Footnotes
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1Profitability is a measure of current profitability, based on information from individual companies' income statements.
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2Asset growth is defined as the change in a company's total assets from the prior fiscal year to the current fiscal year.
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3"The Small Caps That May Be Holding Back Your Portfolio’s Returns," Insights (blog), Dimensional Fund Advisors, February 2022.
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