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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, mutual or exchange traded, attempt to replicate an index, there is usually tracking error between the two.

This may be due to the way that the fund is constructed.

It may also be due to the timing and pricing of transactions when adjusting the fund to reflect changes in the underlying index.

Note that 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.

But there will be some operating and administrative expenses. Trading commissions, shareholder communication, regulatory dealings, portfolio maintenance, are a few such costs.

For example, consider the Standard & Poor’s (S&P) 500 index. A very popular index in the United Stated. Two of the lowest cost tracking funds are the S&P Depositary Receipts (SPDR) S&P 500 ETF (SPY) and the iShares S&P 500 Index (IVV). Both of these funds are very large – SPDR has total assets of USD 95.3 billion, IVV total assets of USD 28.5 billion – which helps keep the costs low in percentage terms. Yet they each still have expense ratios of 0.09%.

Now 0.09% is not much. Especially when you compare that to the category average of 0.47%. But every little bit counts. Over time, that 0.09% will compound to increase its impact on the variance between the actual index and your fund. And should you choose a fund at or above the category average, you will be losing at least 0.47% each year against the S&P 500 results.

Consider recent average annual total returns for the S&P 500 to April 30, 2011. One year returns were 17.22%. Paying almost 0.5% in fund expenses is not onerous. But the three and five year average annual returns were only 1.73% and 2.95% respectively. Paying 0.47% each year in fees would have created a substantial negative performance variance.

So 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.

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