The gap between a tracker and the index it tracks

This is written to be used rather than admired. Each section below is a decision about tracking difference and tracking error, and each one has a default.

Two different measurements

Tracking difference is the gap between the fund's return and the index return over a period, and it is usually negative. Tracking error measures the volatility of that gap, meaning how consistently the fund lags rather than how far behind it ends up.

A fund can show a small tracking error and a large tracking difference if it falls behind by a similar amount every single year. For a long-term holder the difference matters more than the error, because the difference is the money and the error is only the wobble. Provider documents report both, though not always under names that make the distinction between them obvious to a reader.

The charge is only part of it

The ongoing charge sets a floor under how far behind the index a fund will run, since it is deducted from the fund's assets. A fund lagging its index by materially more than its stated charge has other costs, and those are worth understanding before you buy it. A fund lagging by less than its charge is recovering money somewhere, most often through securities lending or favourable treatment of dividend income.

Put simply, comparing published tracking difference across candidate funds is therefore a better cost comparison than comparing their headline charge figures. That comparison needs several years of data, because a single year can be distorted by one unusual index event.

Withholding tax on dividends

Funds receive dividends from companies in many countries, and those payments are frequently subject to tax withheld at source before arriving. The rate depends on where the fund is domiciled and which treaties apply, which is precisely why domicile appears on every fact sheet.

In practice, two otherwise identical funds domiciled in different countries can show persistently different tracking differences for this reason alone. The index itself is usually calculated on an assumption about withholding that may not match any particular fund's actual position. This is genuinely technical, jurisdiction-dependent and subject to change, so published historical numbers are better evidence than the theory.

Sampling and cash drag

Funds tracking very broad indices often hold a representative sample rather than every constituent, because the smallest holdings cost more to buy than they contribute. Sampling introduces a gap that can fall either way in a given year and only averages out across considerably longer periods. Cash arriving from new investors is not invested instantaneously, and cash sitting uninvested during a rising market drags on the reported return.

The useful part is this: large funds with steady flows generally manage this better than small funds receiving lumpy and unpredictable inflows.

Fund size is therefore relevant to tracking quality, even though it tells you nothing at all about whether the index suits you.

Securities lending

Many funds lend holdings to other market participants in exchange for a fee and collateral, and that fee offsets some of the running costs. This can improve tracking difference, which is why certain funds appear to lag their index by less than their stated ongoing charge.

Where it helps most, it also introduces counterparty risk, mitigated by collateral arrangements whose quality and conservatism vary between providers. Providers publish the proportion of the fund available for lending and the share of the resulting revenue passed back to investors. That revenue split is a genuine and disclosed difference between providers, though it is rarely printed anywhere prominent.

Some of this will suit you and some will not, and that is the point.

How much of this to care about

Tracking difference is generally measured in fractions of a per cent, so it will never rescue a badly chosen allocation. It is, however, one of the few fund-level differences measurable in advance rather than being a story about the future.

For most people, for a holding you intend to keep for decades, a persistent annual gap compounds in exactly the way an explicit charge does. Check it once when choosing, and after that only when you are already reviewing the holding for some other reason. Switching funds to capture a very small improvement usually costs more in spreads and time out of the market than it recovers.

The takeaway

The charge tells you the minimum lag. The tracking record tells you what the lag has actually been.

Pick the one that costs you least, and let the rest wait.