E is for (Tracking) Errors
Indexes play an important role in retirement planning. Numerous people use them for their ease of use and convenience (many are located in your company sponsored 401(k) plans) and most importantly, their low cost.
The index funds that do the best job do so because they excel at penny pinching. And that takes more than just a smattering of skill. They must maintain the underlying portfolio, making moves seemingly in an instant each time the index re-balances (doing so before the rest of the traders increase the price of the stock that was added and deflating the stock that is being sold out of the index).
Any difference between the index’s benchmark and the underlying portfolio is considered a tracking error. These tracking errors are particularly pronounced during an unsettled market. Index fund managers may have enormous amounts of cash sitting idly on the sidelines as the markets adjust to news.
They would like to invest it but they, much like the rest of us, are gripped in fear that where they put their money will be the wrong place. Unsure of beefing up one position in favor of another, the money languishes, largely un-invested, while the benchmark moves ahead in most instances, completely unfazed by these decisions.
Measuring These Errors
Just when you thought all you had to do was buy and index and forget about it, along comes this paradox. But how do determine how much of an error is acceptable? The simple answer is chose a fund that is closest to the benchmark. But in the real world, that fund may not be accessible to you (perhaps it is too costly to buy into to or your retirement plan at work doesn’t offer such a beast). In that case, use this measure.
If over the course of a year – not a quarter or a half a year – your index fund’s return is more that five basis points lower than the return posted by the benchmark, you should consider moving your money.
A is for Asset Allocation
B is for Balance
C is for Continuity
D is for Diversity