What Investors Can Learn From Tracking Error

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. What is tracking error, and what information does it yield about mutual funds? Joining me to discuss that topic is Russ Kinnel. He is director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Happy to be here.

Benz: In your most recent issue of Morningstar FundInvestor, you wrote about tracking error. Retail investors might not be familiar with this term. Can you give us a quick definition of what tracking error is?

Kinnel: It's very commonly used in the investment industry, and essentially, it's telling you about volatility in a fund that's not explained by its index's movement. In other words, it's different from standard deviation which tells you the absolute amount up and down, whereas tracking error is telling you how different is it from the index. If the S&P is up 20% and a fund is up 30%, that's pretty different, as opposed to another fund maybe that's up 21% that would have a lower tracking error.

Benz: Lower tracking error means that the fund tends to hew pretty close to the index in terms of its performance. If the tracking error is higher, it means that the fund is all over the place and maybe doing something that's quite different from the index.

Kinnel: That's right, and that's why it's a useful measure of giving you a sense of should I expect indexlike performance. If not, then what should I expect?

Benz: In the most recent issue of FundInvestor you called out some funds in the Morningstar 500 that have very high tracking error. Before we get into those--and I want to take a look at some of them--how did you decide what index to use to compare a fund's performance against?

Kinnel: I used a category-specific index. For large value, that will be Russell 1000 Value; large growth, Russell 1000 Growth. I wanted one that was specific to that category.

Benz: Fairholme Fund is near the top of the list in terms of funds with very high tracking error. Let's talk about what is going on at that fund for people who aren't familiar with it.

Kinnel: Its tracking error is really off the charts, and it makes sense when you think about it from a fundamental perspective, too, in that it's a very focused fund. It's got some very big weights in fairly small, fairly obscure companies, and has had in the past things like AIG or Fannie Freddie preferreds. Some really unusual stuff; not at all common to either the value indexes or value funds.

Benz: Not surprisingly, performance has slid all over the place, too; sometimes looked very, very good and sometimes looked very weak.

Kinnel: That's right. If you look over its history, it's often been very different from really just about any broad market index you'd care to pick. As you say, sometimes that's good, sometimes that's bad. Certainly, it helps to give you some insight. This is clearly not a fund you would expect to behave like the index. This is a fund you want to dig deeper on to understand what's going on. Really, maybe it's not even a core holding because it's so unusual.

Benz: Let's talk about another fund that you highlighted as having high tracking error. That's Hotchkis & Wiley Mid-Cap Value. That fund maybe a little less familiar to our viewers. Let's talk about that one.

Kinnel: This is a more typical example in that it's not owning anything really unusual. As the name implies, it actually owns mid-value stocks. It doesn't have a huge position size. It's top one is a little under 5%, much more typical. But where it is still having tracking error is because it's deep value, and that means it's going to have a lot of exposure to economically sensitive stocks. Even though it's kind of owning stuff that's mostly in the index, the results are still atypical. You see versus the peer group a lot of top decile, bottom decile calendar-year performance. Again, that should inform how you might use that in a portfolio.

Benz: It's one we like. We've got a Bronze rating on that fund. Fairholme Fund is Neutrally rated. Let's talk about a fund that over the years our analysts have had quite a bit of conviction in, that's Templeton Global Bond, also showing up with very high tracking error, and anyone familiar with the strategy probably won't be surprised at that. But let's talk about why it tends to not look like its category peers or the index that its category uses.

Kinnel: It's certainly very different from any global bond index you care to use because Michael Hasenstab really has a very different outlook. He has a strong belief that emerging-markets debt is a much better risk-reward payoff than developed-market debt. You see very little in Europe and Japan, lots in emerging markets, and even has short positions in the euro and the yen, which further emphasize that tracking error, and that's part of why the tracking error has actually grown. But as you say, we rate the fund Gold. Obviously, we think there is a sound a reason for doing what he is doing. It's just, obviously, you have fairly different performance from a more straightforward international bond fund.

Benz: Right, and it seems like this case really illustrates the value of, if you are owning a fund like this, understand what it's doing and try to make sure that it's a fit for your portfolio before adding it.

Kinnel: For sure, and most people don't even think of international bonds as core to begin with. This just adds a little more diversification. It's obviously fairly different from having a high tracking error fund, say, that you may think is giving you U.S. large-caps. This is already a little at the periphery of most people's portfolios.

Benz: You also called out funds that illustrate the opposite, where they tend to hew to their indexes pretty closely. One fund that you named as being pretty tightly correlated over time with its benchmark is T. Rowe Price Equity Income. Let's talk about that one.

Kinnel: We rate this fund Bronze. It's a fairly diversified portfolio, and it's got sector weights not too different from the benchmark. It avoids rather large individual stock bets. It's got a pretty low tracking error. In the two years-plus that Linehan has run it, it's actually done a nice job versus the benchmark, which is encouraging though obviously it's a short time period. This is one you know pretty much what you are getting. This is large value exposure with a bit of an income tilt. You could certainly use this in your portfolio and know exactly what you are getting.

Benz: That's a case with a lot of T. Rowe Price funds. They tend to be pretty true to what their names are and to what categories they are in.

Kinnel: That's right. With these low tracking-error funds, obviously, fees are important because if it's going to be like an index, you certainly don't want to be paying 150 basis points. This one is in the 70s. It doesn't have a big hurdle, and it's a fairly reasonable value proposition.

Benz: Another fund that has low tracking error, tends to hew pretty closely to its benchmark is Vanguard Growth and Income. Let's talk about that one.

Kinnel: This one has got even lower tracking error because it's farmed out to three different quantitative managers. Quantitative managers typically have fairly diffuse portfolios because they feel like their process helps in the aggregate but it's not going to pick out any particular winner. All these quant managers are keeping their sector weightings pretty much in line with the benchmark, so then you add on top of that three managers, and so, you have a very diffuse portfolio with pretty low tracking error. You also have very low fees. The fund, since the three managers came on board in 2011, has modestly beaten the index. You go out 10 years, it's modestly behind, and that pretty well explains the value proposition here. We've got it rated Bronze. It's a decent fund, but certainly year to year you wouldn't expect to be wildly above or below the index.

Benz: In terms of tracking error, it's not a data point that's available on Morningstar.com. Is there a proxy that you would recommend for people wanting to try to get their arms around this issue?

Kinnel: You can look at the R-squared, the Best Fit Index R-squared. That gives you a sense as well. It's not quite the same thing, but it's telling you again how much does this fund behave like its best-fit index. If you see something in the upper 90s, you know it's pretty indexlike. If you see something significantly lower, it may be fairly quirky.

Benz: Last question for you, Russ is, what do I do with this information? How do I combine perhaps funds that have very tracking error with lower tracking error products? Do I use some of both? How would you recommend that investors approach this?

Kinnel: As you can probably tell, I don't really think high or low is necessarily bad; it's how you use it in a portfolio. Low tracking error is a little more predictable, but it also depends on, do you already index funds. If you've got a couple of big holdings in index funds, maybe you don't need anything else with a low tracking error that's in a similar area.

Benz: Maybe don't need anything else, period.

Kinnel: Yeah. But then maybe these high tracking errors are good sort of at the periphery. On the other hand, if you don't have that, if you are still building your core, then these kinds of funds with lower tracking error or index funds themselves are probably good to own. It's really about building that portfolio, having the right expectations. If that tracking error or in the case of R-squared, if that's a surprise to you, then you want to research more so you have an understanding of the fund before you buy.

Benz: Interesting research, Russ. Thank you so much for being with us to share it.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.