Investors tend to view index fund tracking error in a purely negative light. When a fund fails to track its benchmarks particularly well, investors assume that the fund’s manager is probably doing a poor job.
But there may be another story here. Fund Her manager may tolerate tracking errors as a means of avoiding taxable events. After all, every time a fund manager sells or rebalances a position to track a benchmark her index, it’s subject to a tax that degrades the fund’s after-tax performance.
So, do index funds with less tracking error perform better or worse after tax?
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To investigate this question, we pulled data on all US dollar-denominated index mutual funds across six different asset categories: large caps, emerging market equities, fixed income, small caps, US value, and US growth. Each fund was then assigned a tracking error designation (high, medium, low). For each category, we calculated both the median return and the median after-tax return over the last five years.
Tracking error was defined as the standard deviation of the difference between the return of the fund and the return of the tracked index over the annual timeframe.
So what did we find? Large-cap, emerging market, and bond funds with higher tracking errors performed better after-tax than those with lower tracking errors.
large cap fund
tracking error Category |
Median 5 years return |
Median 5 years After-tax return |
low | 9.66% | 4.74% |
middle | 10.43% | 7.83% |
expensive | 10.44% | 7.88% |
Emerging Market Fund
tracking error Category |
Median 5 years return |
Median 5 years After-tax return |
low | 0.36% | 0.08% |
middle | -0.53% | -0.70% |
expensive | 0.78% | 0.35% |
bond fund
tracking error Category |
Median 5 years return |
Median 5 years After-tax return |
low | 0.62% | 0.17% |
middle | 0.90% | 0.30% |
expensive | 1.12% | 0.66% |
For example, large-cap funds in the low-tracking-error category generated 4.74% post-tax annualized returns over the past five years, compared to 7.88% for high-tracking-error funds.
But this is not the full story. Results were quite different in the small-cap, value, and growth fund categories. For each of these asset classes, funds with less tracking error tended to perform better after tax. For example, the median annual return of small-cap funds with high tracking error was 4.99% over the past five years, compared to 5.77% for funds with low tracking error.
small cap fund
tracking error Category |
Median 5 years return |
Median 5 years After-tax return |
low | 7.35% | 5.77% |
middle | 5.36% | 3.72% |
expensive | 6.76% | 4.99% |
US value fund
tracking error Category |
Median 5 years return |
Median 5 years After-tax return |
low | 8.72% | 6.11% |
middle | 7.84% | 5.52% |
expensive | 7.25% | 4.34% |
US Growth Fund
tracking error Category |
Median 5 years return |
Median 5 years After-tax return |
low | 11.37% | 7.96% |
middle | 12.24% | 9.44% |
expensive | 10.67% | 6.17% |
Overall, therefore, our investigation revealed mixed results. We didn’t find fund tracking error to be a good predictor of after-tax performance. Low tracking error doesn’t seem to be an indicator of index fund quality, but high tracking error can, in certain circumstances, allow the fund to avoid taxable events, thereby boosting after-tax returns. can be useful for
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect those of CFA Institute or the author’s employer.
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