A goal of passive investing is to match the market return as closely as possible.

However, it is not a given that a passively structured investment will match the market. In fact, there may be material variations between different investments and the benchmark index.

Index funds (both mutual and exchange traded) are typical passive investments. Here is why they do not normally match their benchmarks.

Operating Costs

Index funds incur operating costs that are not present in the benchmark index.

While there may be little to no management fees charged, there will still be operating expenses for: commissions on buying and selling securities; accounting for fund assets; shareholder communications; regulatory filings; staff salaries; etc.

These costs cannot be avoided. Any fund that you invest in will be at an immediate disadvantage in trying to match the market return.

The more efficient the fund, the lower the relative costs. So even though operating costs cannot be avoided entirely, make sure you compare funds before investing.

Transaction Timing

But even if we could avoid all fund costs, it still may still be difficult to exactly match the benchmark index performance.

Securities need to be bought and sold on the open market to properly track an index.

According to a November 1, 2010 Standard & Poor’s press release, “RightNow Technologies Inc. (RNOW) will replace Res-Care Inc. (RSCR) in the S&P SmallCap 600 index after the close of trading on Friday, November 5.”

If you are an index fund that tracks the S&P SmallCap 600, you may need to sell your holdings of Res-Care and replace them with RightNow. There is no guarantee that the price you receive for Res-Care, or pay for RightNow, will be the same as calculated by the benchmark as at the close of business on November 5.

Compounding this problem is that there are many funds that track this index.

The more funds that track a specific index means more competition for shares of securities added to an index and more sellers of securities that have been removed from an index. If there is suddenly either increased supply or demand, it can cause significant price fluctuations.

When a fund can invest and divest securities may have an impact on its performance versus the benchmark. Think of the price impact on Res-Care as all the tracker funds holding this stock sell their shares. And what will be the short-term price impact on RightNow as these same funds buy all available shares of this stock?

Fund Construction

A second reason for variances between performance in the benchmark index and index funds relates to how the fund is structured.

Not all index funds are created equally.

Index funds may be created using full, partial, or synthetic replication.

Full Replication

Full replication involves holding every security in the index in its appropriate weighting.

With complete replication, an index fund’s gross returns should be close to to the index itself.

As the relative weightings of securities can fluctuate based on security price and capitalization, to stay fully replicated requires frequent trading. How quickly the fund can adjust its portfolio will impact matching gross index returns.

Also, increased trading will increase fund operating costs. This reduces fund performance versus the actual index which does not incur any expenses. The increased fund turnover can also create taxable capital gains for investors, once again impairing net returns.

Partial Replication

Partial replication does not hold all an index’s securities. Instead, it only maintains a representative sample of the securities within the index.

The better the sampling techniques, the closer the gross returns should be to the index. But when not fully replicating an index, there is a greater risk that actual returns will deviate from the actual benchmark or a portfolio using full replication. This is known as the tracking error.

Note that tracking error is not a one way street. The error can also result in a fund achieving higher gross returns than the benchmark.

An advantage of partial replication is that by owning fewer securities, there is less trading (and transaction costs, administration expenses, triggering of capital gains, etc.) than under full replication.

Whether partial replication is preferable to full depends on the quality of the sampling technique.

Synthetic Replication

Whereas full or partial replication requires the fund to own all or some of the benchmark index holdings, synthetic replication does not.

Synthetic replication uses financial instruments to replicate the index performance. These may include the use of futures, swaps, and other derivatives.

An advantage of synthetic replication is that it is usually easier and more cost-effective to re-create and manage the benchmark using financial instruments rather than investing in individual securities.

There still may be some tracking error in performance depending on the specific benchmark index and the availability of financial instruments. For established markets though, tracking error should be small.

A potential problem arises for less established markets where finding an exact match of financial instruments is not simple. In these instances, the fund may need to rely on a less than perfect fit in trying to replicate the market. This will increase tracking errors.

Also, it may require the fund to enter into swaps with other entities to replicate the benchmark index. This creates counterparty risk (risk that one side of the transaction will not fulfill its obligations) and can impact fund performance should the counterparty default.

While trading and administrative costs are reduced with no actual securities being owned, there are still costs associated with a synthetic strategy. These include fees associated with the financial instruments used. In established markets, there are many options for replication, so the costs tend to be reasonable. But in less established markets, it may not be as easy to find replication solutions and the costs will rise.

I do not think it is imperative that you memorize this post as the mechanics of funds is simply a reality that everyone must deal with.

But always keep in mind that a passive investment may not exactly match the market. And the reasons for that lie (mainly) in the above points.

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