Tracking Error: When Good Returns Aren’t So Good

150 150 Mia

2014 has been a strong market year and appears to be wrapping up with a full head of steam heading into 2015.  I think it’s safe to say most investors are happy with their portfolio returns. As of December 23rd, the S&P 500 index is up 12.6% for the year, making up for negative returns in international markets and near-zero percent bond rates.

But when you get your year-end performance report from us later this month, it is likely you will see that your portfolio, while up for the year, trailed its benchmark by a small amount (likely less than 1%). Is that a big deal? Well, I’d say “no,” but it’s hard to make the argument that my opinion is completely objective. So let’s talk about why your portfolio behaved the way it did and whether it presents a problem going forward.

Your portfolio is compared to a benchmark composed of three indexes: The S&P 500, the MSCI EAFE and the Lipper Short Term Bond Index. The performance of all of your US equity holdings is compared to the S&P 500 performance, your international equity performance is compared to the EAFE and the return on all of your bond holdings is compared to the Lipper. This means to the extent that the actual composition of your portfolio strays from the composition of the indexes, your return will be different.

We call this “tracking error” even though it is in fact not an error at all. We deliberately build portfolios that don’t match broad indexes. Specifically, we tilt portfolios so that they hold more value stocks and more small-cap stocks than the equity indexes do.

Bottom line: In years that value and small stocks do well, you will have positive tracking error, or to put it in English, you’ll beat the benchmark. And in years that value and small under-perform, well, you get negative tracking error. This year, the latter happened. In fact, the US large equity fund that we use for most of our clients outperformed the S&P 500 by more than 2%, but large value stocks trailed by 1.4% and U.S. small stocks only had a 4.2% return, more than 8% below the benchmark.

Results were better internationally, although both the index and the funds we use were slightly negative for the year. Figures are in the table below:

Fund Returns vs. Indexes 1/1/14-12/23/14

 

12/31/2013 Close

12/23/2014 Close

%
Change

US      
S&P 500 1848.4 2082.2 12.6%
DFA Large 14.29 16.40 14.8%
DFA Value 30.88 34.35 11.2%
DFA Small 29.83 31.09 4.2%
       
International      
EAFE 1915.6 1784.6 -6.8%
DFA Value 18.98 17.91 -5.6%
DFA Small 18.12 16.97 -6.3%
Index and fund value from yahoo.com/finance

So what does this mean? It means some years we don’t get the premium for investing in the slightly riskier asset classes of small cap and value. We know that will happen because that is what makes those asset classes riskier – that they will underperform some years, but over many years will give us a superior return to the benchmark. And that is what you should see in the returns you have gotten since you became a Northstar client, if you have been with us for a few years.

We are confident the risk premium still exists in the portfolios we create for our clients. Meanwhile, we can all look back at a good year in capital markets.

 

Steve