Why Two Funds Tracking One Index Diverge

Two funds can follow an identical index and still report different returns over the same period. The gap is small but it is systematic, and every part of it has an identifiable cause.

An index is not investable in itself

An index is an arithmetic construction. It assumes holdings are bought and sold instantly at published prices, with no dealing costs and no cash sitting uninvested.

A fund has to do the buying in the real world, where trades move prices slightly and settlement takes time. The difference between the theoretical and the actual is where divergence begins.

Tracking difference is the term for the total gap over a period, and tracking error describes how variable that gap has been. They measure related but distinct things.

Charges are the largest predictable component

The fund's ongoing charge is deducted from assets continuously, so it drags on returns whether markets rise or fall. It is the one component known in advance.

Two funds on the same index with different charges will separate over time roughly in line with that difference. This is arithmetic rather than skill.

Costs disclosed inside the fund are not the only ones a holder pays, since dealing spreads and platform fees sit outside the ongoing charge and vary by route and jurisdiction.

Dividend treatment changes the picture

Index providers publish price versions, which exclude dividends, and total return versions, which assume they are reinvested. Comparing a fund against the wrong version produces a misleading gap.

Total return indices also come in gross and net forms, differing in the withholding tax assumed on dividends. A fund's actual tax treatment depends on where it is domiciled.

A fund that recovers more withholding tax than the index assumes can appear to outperform. That is an accounting effect, not evidence of superior management.

Rebalancing has to be executed

Indices change their constituents on scheduled dates, adding and removing companies according to published rules. Funds must trade to match the new composition.

Because many funds trade around the same moment, the prices they achieve can be worse than the closing prices the index uses. That execution shortfall is shared across holders.

Some funds trade ahead of or after the official date to reduce this effect, accepting a small mismatch in exchange for better prices. Different choices produce different results.

Securities lending shifts the balance

Many funds lend holdings to borrowers who post collateral and pay a fee. Some or all of that fee is returned to the fund, offsetting costs.

Lending introduces its own considerations around collateral quality and counterparty exposure, and policies differ substantially between funds and between regulatory regimes.

Two funds with identical charges can therefore land in different places purely because one lends more actively than the other. The published policy explains most of the difference.