Why You Shouldn’t Be So Worried About Tracking Error

Tracking error is somewhat related to index investing as an index is often used as a benchmark when calculating a given fund's tracking error. Moreover, the goal of "passive" investing is to mimic the returns of an index, minus fees. Many mutual fund managers are "graded" based on how they perform relative to a particular benchmark. In an attempt to exceed the benchmark, fund managers will often increase the risk in their funds. However, if a fund manager is simply trying to keep pace with an index, then it might be better to buy a lower-cost index fund. 

Moreover, if an investor doesn't mind running with the "herd" then an index fund may be appropriate. This is because an index fund tracks with a large universe and as a result, a few hot stocks will have a lesser impact on total return. 

Does Index Investing Carry Greater Risk?

There is an inherent problem with passive investing related to the index chosen. For example, during the meteoric rise in the 1990s, the S&P 500 Index became very tech heavy as technology stocks outperformed. By the time the tech bubble burst, technology was such a large component that when it did crach, the S&P fell hard. Therefore, a cap-weighted index such as the S&P 500 may not be in the best interests of the investor, especially on the way down. 

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