Index benchmarks for passive investment management are an ideal fit.
And quite easy to implement.
After all, with passive investing you are simply trying to replicate the market (as represented by the relevant index). So it is simple to find an index for comparative purposes.
But there are a few things to remember when benchmarking under a passive approach.
Index Funds Under-perform Benchmark Indices
No matter what passively managed index fund you invest in, mutual or exchange traded, it should under-perform it’s relevant benchmark index.
The goal is to try to get as close as possible to the benchmark.
Here are two reasons why an index fund will not exactly match the benchmark index.
Tracking Error
When index funds attempt to replicate an index, tracking error between the two typically occurs.
There are usually two reasons for tracking error in index funds.
How a fund is constructed to replicate the index causes tracking error.
Also, timing and pricing of transactions in adjusting the fund to reflect changes in the underlying index creates errors.
Tracking errors can go both ways. At times, the timing of transactions and the method of index replication may cause the error to result in a positive variance.
Your goal is to find funds with minimal tracking error. That will ensure you come as close as is possible to matching the index’s returns.
Fund Fees and Expenses
There will be certain costs associated with managing any fund. Fees that an actual benchmark index does not incur.
Management fees in index funds should be de minimis, if not zero. If there are management fees charged in a passive index fund, think twice about investing. And never pay a sales commission (a.k.a., load).
But there will be some operating and administrative expenses. Trading commissions, shareholder communication, regulatory dealings, portfolio maintenance, are a few such costs.
Even with index funds, there can be significant differences in fees and expenses. Pay attention to fund costs. Minimize, minimize, minimize.
Even if you are investing in an index fund, you will not exactly match the index’s return.
Your objective though is to get as close as possible.
