Which Fund Offers a Lower Divergence in Performance?
Small cap index funds, while offering potential growth opportunities, often have a higher tracking error compared to their large cap counterparts. This discrepancy can primarily be attributed to liquidity constraints and the complexities involved in replicating small cap indices.
Tracking error, a metric used to measure how closely an index fund follows its underlying index, is higher in small cap index funds due to lower trading volumes and wider bid-ask spreads. This makes precise replication of the index more difficult and costly, leading to increased tracking error.
Small cap indices are also more volatile and less concentrated than large cap indices, adding to the challenge of accurate fund replication. These market characteristics contribute to the higher tracking error in small cap index funds.
Despite the higher tracking error, small cap index funds are not necessarily less advisable for investment. The key consideration for investors is understanding that tracking error is a natural byproduct of index fund management, especially in less liquid and more volatile segments like small caps.
Compared to active management, index funds, including small cap ones, generally have lower costs and tend to outperform a majority of active funds over time, despite their tracking errors.
From a portfolio perspective, small cap index funds provide diversification benefits and exposure to potential higher growth from smaller companies, albeit with higher volatility and tracking error. The suitability of small cap index funds depends on the investor’s risk tolerance and investment horizon. Those who can tolerate the increased volatility and tracking error may find small cap index funds a valuable part of a diversified portfolio.
Here's a comparison of large cap and small cap index funds:
| Aspect | Large Cap Index Funds | Small Cap Index Funds | |-------------------------------|-----------------------------------|------------------------------------| | Tracking Error | Lower due to higher liquidity | Higher due to lower liquidity and higher volatility[1][5] | | Liquidity of Stocks | High | Low to moderate | | Replication Complexity | Lower | Higher | | Volatility | Lower | Higher | | Suitability | Broad market exposure, lower risk | Higher risk and potential reward, requires conviction in strategy[4] |
In conclusion, a higher tracking error in small cap index funds should be viewed as an expected market feature rather than a flaw. Investors should weigh this factor in the context of their overall investment goals and risk appetite.
[1] Investopedia. (2021). Tracking Error. [online] Available at: https://www.investopedia.com/terms/t/trackingerror.asp
[2] Morningstar. (2021). Small Cap Index Funds. [online] Available at: https://www.morningstar.co.uk/uk/funds/category/small-cap
[3] ValueWalk. (2021). What is the Tracking Error of an Index Fund? [online] Available at: https://www.valuewalk.com/2019/07/what-is-the-tracking-error-of-an-index-fund/
[4] Motley Fool. (2021). Small-Cap Stocks: The Risks and Rewards. [online] Available at: https://www.fool.com/investing/2021/02/22/small-cap-stocks-risks-and-rewards/
[5] Investopedia. (2021). Small-Cap Stocks. [online] Available at: https://www.investopedia.com/terms/s/smallcap.asp
Small cap index funds, despite their higher tracking error, can still be a worthwhile investment for those willing to tolerate the increased volatility and risk. In the world of personal-finance, small cap funds offer a way to gain exposure to smaller, potentially high-growth businesses, which may not be available in larger, more established companies. This diversification is important for a sound business or personal-finance strategy. When it comes to comparing them with large cap index funds, investors should bear in mind that while large caps have lower tracking error due to higher liquidity, small caps can provide more opportunities for investing in emerging businesses that might outperform the wider market in the long run.
