Index Design and Implications for Index Tracking

Over the past decade the growth of index funds has been substantial. This period has also witnessed increased availability of new index-linked products (e.g. exchange traded funds) and the computation of new market indices and sub-indices. While the objective of index funds is to replicate both the returns and risks of the underlying index, tracking error in performance is unavoidable. Tracking error arises because the underlying index is measured as a ‘paper’ portfolio, and the index assumes perfect replication can be achieved instantaneously and without cost. While index mutual fund managers will attempt to minimise tracking error, an important distinction is that tracking error can be decomposed into two components – exogenous tracking error (index rules and maintenance procedures applied to the underlying index) and endogenous tracking error (induced from the individual activities of index managers managing open-end passive funds). While endogenous tracking error can be influenced by index mutual fund managers, the second component of tracking error (associated with the indexes’ design and maintenance procedures) is beyond the direct control of the index fund manager. Employing a sample of S&P 500 index mutual funds, this paper examines the exogeneity of tracking error that arises from changes in the Index Divisor. The paper identifies a number of exogenous factors that are important determinants of tracking error for S&P 500 index funds.