Don’t get confuse by tracking error of ETFs as it is calculated on its NAV and not on the actual price at which investors buy and sell ETF units.
MFDs/RIAs refer to factors like performance, volatility, strategy, peer group benchmarking and so on to evaluate performance of active funds. However, evaluating a good passive fund for your clients is simple as there is no attempt beat the index. Basically, you have to look at two major aspects to pick a good passive fund – tracking error and tracking difference.
Remember, passive funds will never outperform its benchmark due to expenses, cash component to manage redemptions in index funds and actual tracking error. While we cannot control the first two factors, tracking error can give us a better picture to select passive funds.
Tracking error measures the extent to which returns of your fund has deviated from its underlying index. Statistically, tracking error is the difference between annualised standard deviation of the fund and its benchmark. It does not distinguish between positive deviation (better than index) or negative deviation (lower than index). An index fund manager needs to calculate his/her tracking error on a daily basis, especially if it is an open-ended fund. Tracking error is calculated against the Total Returns Index (TRI) which shows the returns on the index portfolio, inclusive of dividend. You may check tracking error of passive funds on fund factsheet.
Interestingly, tracking error does not create much difference in ETFs. ETFs are bought and sold at their market price, which can be slightly different from their NAV. Tracking error of ETFs is computed based on their NAVs, which is the closing price of the day, and not the actual price at which an investor has bought/sold the units. So, the computed tracking error is just an indicative number.
Another interesting point is tracking error of an ETF changes for investor to investor even if they buy or sell on the same day. However, tracking error of an index fund remain unchanged throughout the day.
Tracking difference is simply the difference between returns generated by a passive fund and its underlying index. The popular method of looking at active funds is point-to-point returns over horizons like 1 year, 5 years, 10 years, etc. For passive funds, the extent to which the return is lower than the defined index, over horizons of say 1 year, 5 years or 10 years is the tracking difference.
Conclusion
For investors, tracking difference is a simple, easy-to-understand and practical metric. For MFDs/RIAs, tracking error gives a better insight for comparing passive funds.
Source: https://cafemutual.com/news/guestcolumn/594-how-to-select-passive-funds-for-clients