Tracking Error: What is it, and why does it matter?

During several recent discussions with clients, I’ve heard a common question, “Why isn’t my portfolio doing as well as the market?”  This inquiry, of course, leads to another question: “What is the market?” To most investors, the market is either the S&P 500 or the Dow Jones Industrial Index. While these two indices are often cited by news outlets, they only cover portions of the larger global market.

At Merriman, we have long advocated that the allocation of the equity portion of your portfolio include large company stocks, small company stocks, international stocks, emerging market stocks and real estate investment trusts. Each of these asset classes perform differently over time, sometimes dramatically so. Tracking error, the way we refer to it here, is the amount by which the performance of a portfolio differs from that of the major market indices. In some years, this difference will be positive, meaning your portfolio outperformed a major index like the S&P 500. However, there will be years like 2011 when these additional asset classes will lead your portfolio to underperform the S&P 500.

To show how tracking error can affect year by year returns, let’s look at two separate time periods.

First, 1995-1999. This was a period in which US stocks, especially growth stocks, did extremely well. The 100% equity portfolio underperformed the S&P 500 in 4 out of 5 years, often by a significant margin. This was because small cap and international stocks didn’t do nearly as well as US large cap growth stocks did.

For the first few years, if you were following Merriman’s strategy you probably would have stayed the course. If you were a Merriman client, your advisor would have been selling U.S. large cap stocks and investing in international or small cap stocks. However, in 1998, $150 billion flowed into domestic stocks, while only $8 billion went into international/global stocks. In 1999 it was $176 billion to $11 billion(1). Put yourself in this position and try to determine if you would have been able to stay the course. Every cocktail party you went to, your friends would mention how rich they were getting on technology stocks. Meanwhile, you owned some tech stocks, but you were also heavily invested in international markets, which weren’t the buzz among those gathered around the cheese and crackers. Why was your money invested there? Money continued to flow into the U.S. markets; in fact in the first quarter of 2000 capital appreciation funds averaged $48 billion per month of net new money versus $9.8 billion per month during the same period in 1999(1). If you were consistently comparing your account to the S&P 500, this would have likely shaken your confidence in Merriman’s diversified strategy.

Now let’s review 2000-2004. In this 5 year time period, the tracking error versus the S&P 500 was positive by a significant margin in each of the 5 years. This was a time in which it was easy to be in an allocation that looked so different than the popular S&P 500 benchmark. This portfolio continued to out-perform through 2006. However, just as before, investors wanted to start allocating more to small cap stocks and emerging markets. Using the same disciplined approach to re-balancing, Merriman was selling the hot sectors while moving money back into US large cap stocks during these years.

Overall, we recommend an equity allocation with wide diversification within the U.S., international and emerging markets. This portfolio will perform differently than the S&P 500 over time, with the long-term returns expected to be higher. With a diversity of asset classes, there will surely be years in which the performance of your portfolio is lower than that of a popular benchmark. Just as each investor needs to understand the level of risk in his or her portfolio, he or she also needs to understand the possible tracking error in the portfolio and how to respond to it. Working with an advisor here at Merriman can surely help you stay the course. Your advisor helps ensure that you avoid excessive risk and relates portfolio decisions back to your long term financial goals, allowing you to focus on more enjoyable things in life. By utilizing an advisor and increasing your awareness of your own natural response to tracking error, you will better weather the emotional hurdles that can accompany the ups and downs of market movements.

¹ http://www.ici.org/pdf/per07-02.pdf