Understanding excess return and tracking error - …

1 Understanding excess return and tracking errorExcess returnAnnualized fund returns often are amongthe first measures advisors consider whenevaluating investment products. But howwell ETFs and index mutual funds performversus both their benchmarks and theircompeting products is just as return , which can be positive ornegative, tells you the extent to which a fund has out- or underperformed itsbenchmark index. It is calculated as thefund s net asset value (NAV) total returnminus the benchmark s total a fund s NAV total return includesfund expenses, excess return typically isnegative for index funds. excess return shows how a product s performance compares with that of itsbenchmark over a stated period of time. tracking error indicates the consistency of a product s excess return during thatsame time period. It is the annualizedstandard deviation of excess return datapoints for the given time period. If total return is your primary criterion, then excess return will likely be moreimportant than tracking error in your ev aluations.

2 If performance consistency is an important consideration, then tracking error may be more relevant. excess return and tracking error data,especially if they are drawn from short time periods, should be used forreference only. Comparisons among products and indexes can be difficultbecause of differences in indexing implementation methodologies and how data are return and tracking error are measures that can help you evaluate ETFsand index mutual funds as you assess the best products for your clients portfolios. But to use the measures effectively, you need to understand whateach one represents and how much weight to give each in your errorTracking error is calculated as the annualizedstandard deviation of excess return datapoints. While excess return measures theextent to which an index product s return differs from that of its benchmark index, tracking error indicates how much variabilityexists among the individual data points thatmake up the fund s average excess simplified, hypothetical example aboveshows how the average performance and negative excess returns of two indexfunds with the same benchmark comparewith a baseline of their benchmark s average 2%0.

3 0% }}Benc hmark average re turn baselin eFund A had a hi gher av erage exces s r eturn and was t he better-performing product. Fund B had a lower av er age ex ce ss return a nd deli vered lower p er for manc e to inv es d A a verage e xcess retu rn Fun d B a verage excess retu rn excess return relative to benchmarkTimeThis hypothetical example does not represent any particular investment. excess return compares a fund s total return with the return of its benchmarkIf performance consistency is an importantconsideration, then tracking error may be more the hypothetical example above, investorsseeking higher long-term returns may findFund A the better choice. However, short-term traders seeking better performanceconsistency may be attracted to Fund B,despite its lower average excess examples may not showsuch aclear-cut tradeoff between excess returnand tracking error . A superior product would have both a higher excess return and lower tracking graph above shows the individual datapoints that make up the averages in ourhypothetical example.

4 tracking error helpsgauge the distribution of the individual data points relative to the fund s averageexcess excess return and tracking error in your evaluationsWhen selecting the best indexing productsfor your clients portfolios, it s important to keep excess return and tracking error in total return is your primary criterion, thenexcess return will likely be more importantthan tracking error in your evaluations. 0%0. 2%FundAhad hi gher track inger r, it sti ll delive reda hi gherav eragere tu g error .Howeve r, ave rage returnto in vestor s hmarkave ra gere turn ba se lin eFund A ex cessreturnFund A av er ag e excessreturnFu nd B excessreturnFu nd B avera geexcessre turnFund A tracki nger ro rFund B trackin g er rorExcessreturnrelativetobenchmarkTi meThis hypothetical example does not represent any particular error indicates the variability of a fund s excess return 2009 The Vanguard Group, Inc. All rights reserved.

5 INTUTE 082009 All funds are subject to market risk, and there is no assurance that a fund will achieve its stated objective. Investors cannot investdirectly in an index. Past performance does not guarantee future INSTITUTIONAL AND QUALIFIED INVESTORS ONLY. NOT FOR PUBLIC International Institutional Asset Box 2900 Valley Forge, PA 19482-2900 Important calculation nuances can distort comparisonsDifferences in indexing implementationmethodologies and the methods used byproduct and index providers to calculate performance can make comparisons example, excess return and trackingerror are derived from periodic performancecalculations. These calculations are greatlyinfluenced by the pricing mechanisms usedto determine the beginning and ending values for the time periods in question. Common variations for determining benchmark and product pricing, which in turn affect excess return and trackingerror calculations, include: Using NAV pricing versus market pricing.

6 Calculating international securities pricingbased on constituent values when foreignmarkets close or fair-value pricing whentrading concludes in the United States. Factoring in foreign exchange rates at various times or when markets close. Determining closing prices using the lastrecorded trade versus a level betweenmarket bid and ask of how returns are calculated,performance information should be usedfor reference only, especially if it is drawnfrom a short time period. The pricingmethodologies used for products andbenchmarks do not reflect the actual experience of an , it s important to note that excessreturn and tracking error are only two of many measures that advisors may want to consider when selecting the best ETFs and index mutual funds for their clients needs. Connect with Vanguard > >+1 >