Investors are likely to view an index fund’s tracking error as purely negative. If a fund doesn’t track its benchmark particularly well, investors assume that the fund manager might be doing a poor job.
But there may very well be a special story here. The fund manager may allow tracking error to avoid taxable events. This is because each time a fund manager sells or rebalances a position to trace the benchmark index, it’s a taxable event that reduces the fund’s after-tax performance.
So do index funds with lower tracking error perform higher or worse after taxes?
To examine this issue, we retrieved data on all U.S. dollar-denominated index mutual funds in six different asset categories: large-cap equities, emerging market equities, fixed income, small-cap equities, U.S. value, and U.S. growth. We then assigned each fund a tracking error label: high, medium, or low. For each category, we calculated each the median return and the median after-tax return over the past five years.
We defined tracking error as the usual deviation of the difference between the fund’s returns and people of the tracked index over an annual period.
So what have we found? Large-cap equity, emerging market and bond funds with high tracking error performed higher after-tax than their counterparts with low tracking error.
Large cap funds
| Tracking error category |
Median five years To return |
Median five years Additional tax return |
| Low | 9.66% | 4.74% |
| center | 10.43% | 7.83% |
| High | 10.44% | 7.88% |
Emerging market funds
| Tracking error category |
Median five years To return |
Median five years Additional tax return |
| Low | 0.36% | 0.08% |
| center | -0.53% | -0.70% |
| High | 0.78% | 0.35% |
Pension funds
| Tracking error category |
Median five years To return |
Median five years Additional tax return |
| Low | 0.62% | 0.17% |
| center | 0.90% | 0.30% |
| High | 1.12% | 0.66% |
For example, the low tracking error large-cap equity fund category delivered an annual after-tax return of 4.74% over the past five years, while its high tracking error counterpart returned 7.88%.
But that is not the entire story. The results were completely different within the small cap, value and growth fund categories. For each of those asset classes, funds with low tracking error tended to have higher after-tax performance. For example, small-cap funds with high tracking error achieved a median annual return of 4.99% over the past five years, in comparison with 5.77% for his or her low tracking error peers.
Small cap funds
| Tracking error category |
Median five years To return |
Median five years Additional tax return |
| Low | 7.35% | 5.77% |
| center | 5.36% | 3.72% |
| High | 6.76% | 4.99% |
US value funds
| Tracking error category |
Median five years To return |
Median five years Additional tax return |
| Low | 8.72% | 6.11% |
| center | 7.84% | 5.52% |
| High | 7.25% | 4.34% |
US growth fund
| Tracking error category |
Median five years To return |
Median five years Additional tax return |
| Low | 11.37% | 7.96% |
| center | 12.24% | 9.44% |
| High | 10.67% | 6.17% |
Overall, our research yielded mixed results. We didn’t discover a fund’s tracking error to be a superb indicator of after-tax performance. A low tracking error didn’t seem like an indicator of an index fund’s quality, although in certain situations the next tracking error might help funds avoid taxable events and thereby increase after-tax returns.
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Photo credit: ©Getty Images / matejmo
