Doug Goodwille from Kayne Anderson speaks to Drew Meredith from The Inside Network on market thinkers.
While a surging gold price is on hold as the world adjusts to a Trump presidency, all the factors that saw its price rise more than 50 per during his first term in office – trade disputes, fiscal deficits and geopolitical tensions – are almost certainly guaranteed the second time around.
Tricks of the trade
There is no shortage of investment ideas available to self-directed investors, nor any lack of ‘fool-proof’ money-making strategies. The level of certainty with which most investment ideas are delivered to the masses belies the inherent complexity of markets. In this environment, the more tools that any investor has at their disposal the better.
The role of a financial adviser involves acting as something of a ‘filter’ between the many new and existing investment ideas, and those families that have entrusted us with guiding the investment of their life savings. In over a decade of experience I have seen almost everything and learned a lot, but one of the most powerful tools I have picked up is ‘tracking error’.
The ‘passive versus active’ debate has dominated headlines since the introduction of the “index fund” by Vanguard many decades ago. But the most commonly used statistics do a disservice to the discussion, as they give no consideration to how active the active managers actually are.
The concept of ‘tracking error’ is among the most straightforward ways to measure the ‘activeness,’ for lack of a better word, of the manager, exchange-traded fund or listed investment company you are buying. Put simply, tracking error is the difference between the movements in the price of a portfolio of investments, a fund for instance, and the movement in the price of the benchmark or index which it seeks to outperform.
It is measured using a standard deviation approach and is among the most accessible data for every fund manager to measure and provide to investors. An index fund, which has the sole purpose of tracking the underlying index, should have a tracking error of close to zero; yet this is not always the case. A truly actively managed fund will have a tracking error upward of 1 per cent to 2 per cent.
What this means is that the fund has performed significantly differently from the index, both positively and negatively. Referring back to the active vs. passive debate, it clearly doesn’t make sense to include ‘actively’ managed funds that have tracking errors of less than 1 per cent in any debate.
There are many uses of tracking error, but ultimately it is to determine if a fund manager is doing what it said it would. By evaluating the historical tracking error of a fund, you can get an idea of how far the manager has been willing to differ from the index in the past, and thus how far it is likely to differ in the future. It really answers the perennial question, ‘why pay an active manager if you are just getting index performance?’
Managers are acutely aware of tracking error, particularly when they start to receive significant institutional mandates from pension funds and the like. These sort of investors have every possible opportunity in front of them, hence every manager is easily replaceable if they underperform; this tends to lead to lower tracking error and benchmark performance in the larger active funds.
One of the more common uses of the tracking error measure is to build a core-satellite type allocation to, say, domestic equities. The ‘core’ portion of the portfolio would be a very-low-cost index fund with nearly zero tracking error. The satellite is then used to invest into truly active managers with significant tracking errors, who are really seeking to move the dial in terms of returns and the implementation of their fundamental analysis.
Ultimately, if a manager is delivering low average returns and has a large tracking error, you are most likely better off in an index fund.
