Index Fund Machine Ch. 2: Tracking — Why the Fund Is Never Exactly the Index

Investment Background

Chapter 1 covered how an index is defined. This chapter covers how a fund actually goes about holding it, and why it can never do so perfectly.

The distinction matters, and most investors never notice it:

An index is a calculation on paper. It does not trade, pay commissions, pay taxes, or hold cash.

A fund is a real portfolio that must confront every one of those.

A gap between them is inevitable, and it can be measured before you buy.

The Wall Street Translation

Where the Gap Comes From

Listing the sources produces a checklist you can use directly to compare funds.

Source	Mechanism	Direction
Management fee	Deducted daily from NAV	Always negative, and predictable
Trading costs	Spreads and impact on rebalancing and flows	Negative
Cash drag	Cash held did not participate in the rise	Negative (in rising markets)
Dividend reinvestment lag	A gap between receipt and reinvestment	Usually slightly negative
Sampling error	The fund holds a subset of the index (below)	Either direction
Securities lending income	Lending shares to short sellers for a fee	Positive — Chapter 3's subject

Note that the last row is positive.

This explains something that looks strange at first: some index funds return slightly more than the index they track.

That is not manager skill. It is usually securities lending income offsetting part of the fee.

Full Replication Versus Sampling

A fund can hold an index two ways, and the choice has real consequences.

Full replication: hold every constituent at its exact index weight.

Advantage: the most precise tracking. Disadvantage: for a broad index containing thousands of stocks, many barely traded, the cost of buying them may exceed the precision gained.

Sampling (or optimization): hold a representative subset, statistically matched to the index's characteristics.

Advantage: lower cost, especially for bond and emerging market indices. Disadvantage: it creates tracking error, because the subset does not behave exactly like the whole.

A practical rule of thumb:

Index type	Usual approach
Large-cap (e.g. S&P 500)	Full replication — liquid, cheap
Total market (including micro-caps)	Partial sampling
Bond indices	Almost always sampled — too many issues, most barely trade
Emerging markets	Sampled

The bond row deserves note: a "total bond market" index may contain tens of thousands of bonds, most of which rarely trade. No fund actually holds them all.

That is not a defect but a necessary engineering compromise. It does mean bond index funds typically carry larger tracking error than equity ones.

Two Metrics That Must Be Distinguished

This is the chapter's most practical section, because both numbers are published and they measure different things.

Tracking difference: the gap between fund return and index return.

For instance: the index rose 10%, the fund rose 9.9%, so the tracking difference is −0.1 percentage points.

That number should roughly equal the expense ratio, plus or minus the other factors.

Tracking error: the volatility of that gap.

It measures not how far behind, but how unstably far behind.

Why both matter:

Case	Tracking difference	Tracking error	Reading
Fund A	−0.05	Very small	Ideal — steadily just below the index, consistent with fees
Fund B	−0.05	Large	Similar on average, but swings widely each year — suggests execution problems
Fund C	+0.02	Small	Usually securities lending income (Chapter 3)

Fund B is the one to watch: an acceptable average concealing unstable execution.

A Necessary Qualification

Tracking precision is not the only goal, and maximizing it creates new costs.

A fund can push tracking error very low by trading frequently — and that trading generates costs and taxable events that ultimately damage your real return.

So the correct objective is not "minimum tracking error" but "net return closest to the index after all costs."

A concrete example: following the index precisely on rebalancing day (Chapter 1) means buying when everyone else is buying. A fund with slight flexibility to complete adjustments over several days shows larger tracking error and may deliver better actual returns.

Which is also why Chapter 1 said: do not choose a fund on a single metric.

Executable Trading Rules

1. Find the tracking difference on the fund page and compare it to the expense ratio. The chapter's most practical line. If the tracking difference is materially larger than the fee, ask why. If it is smaller (or positive), securities lending is usually at work.

2. Understand that bond index funds naturally carry larger tracking error. Do not hold them to an equity fund's standard. It is an inevitable consequence of sampling, not poor management.

3. Look at both tracking difference and tracking error. The first tells you how far behind on average, the second how consistently. A stable small lag beats an equal average with wide swings.

4. Do not switch funds over tiny tracking differences. The tax cost of switching usually exceeds a few hundredths of a percentage point (Poor Charlie's Almanack ch05).

5. Use these metrics for the initial choice, not for ongoing monitoring. Once a year is plenty. Looking more often only tempts you into switches whose costs exceed their benefits.

Relevance to a Retirement Portfolio

This chapter's application for retirees concentrates on one decision: the one time you choose your core holding.

Because once chosen, you may hold it for twenty or thirty years — and in a taxable account, switching is expensive.

So it is a decision worth fifteen minutes to get right.

The concrete checklist:

Check	Where to find it	What you want
Expense ratio	Fund page	Very low for a broad index
Tracking difference	Annual report or fund page	Roughly equal to the fee, or better
Tracking error	Annual report	Stable, with no anomalous years
Replication method	Prospectus	Full replication for equities, sampling for bonds is normal
Fund size	Fund page	Very small funds carry closure risk

The last row deserves explanation, because it is a real and overlooked risk:

Very small funds can be closed. When that happens the fund is forced to liquidate and distribute cash — which in a taxable account forces you to realize all capital gains at a moment you did not choose.

A purely structural risk, unrelated to markets, entirely avoidable by choosing a fund of sufficient size.

Which is this book's purpose: it does not tell you whether to index — six books already answer that. It tells you how to avoid the problems that have nothing to do with markets and everything to do with the container itself.

Chapter 3 covers a mechanism almost never explained to retail investors: your fund lends your shares to other people.