Direct Index Tracking Error - Is It Important?
Part 2 of "Absolutely, Positively, Yes! Direct Indexes Make Sense for Investors Worth Less Than $1MM and Over $5MM"
This is a continuation of our responses to Jerry Michael's and Brent Sullivan's conversation on LinkedIn.
Objection: Tracking error
Jerry's Response: The concern here is that small direct index accounts will suffer large tracking error due to the need to round each security holding to whole shares – in particular, the need to round down a lot of smaller positions weights to 0. Our experience is that for US large cap equities, this only starts being a problem for accounts below about $50K. Assuming a 50% allocation to US large cap, this means direct indexes can work for accounts as small as $100K. Once fractional shares become more widely available (admittedly, a prospect that forever seems just around the corner), this minimum drops to about $100.
You might ask why folks worry about tracking error in the first place. After all, it's not something most investors care about. The real worry here is not tracking error, per se, it's the risk that the direct index will miss out on a big rally by not owning some star performer – think NVidia, Tesla, Apple, etc. But in 20 years of working with direct indexes, we've never seen this be a problem in practice. Yes, there's tracking error, but it's usually lower than the documented taxes saved or deferred. And this sets up a "heads I win; tails I don't lose" situation: if tracking error results in a positive return relative to the index, great; and if it results in negative return relative to the index, well, this negative return is less than the value of the tax management, so you're still better off.
GMAM's Response: The issue of tracking error is often overstated, especially when considering a Compact DI approach. With Compact DI, we avoid the inefficiencies of owning hundreds of fractional positions, many of which may contribute little to overall performance. Instead, we focus on a more concentrated selection—22 stocks versus 220—eliminating the need to hold stock #218, which might represent 0.1% of the portfolio and leave clients wondering, "Why do I even own this?"
This focus not only reduces unnecessary complexity but also ensures the portfolio aligns more closely with clients’ understanding and expectations. The dilution of returns that can occur with excessive holdings is minimized, providing a sharper investment thesis.
Regarding tracking error, Jerry’s point is valid—most clients are not asking, "What is the tracking error?" The reality is, tracking error can be explained simply as: "We will purchase approximately [X] stocks to reflect the performance of the index. At times, it may underperform or outperform slightly, but over the long run, it will closely mirror the returns of the index."
In practice, any tracking error tends to be offset by the benefits of tax management. It's the classic "heads I win; tails I don't lose" scenario: even if there's a small deviation from the index, the value derived from tax savings or deferral usually outweighs it
Comment from Brent: "This paper and its predecessor come up often when I hear these types of "omission error" arguments. The main point being that wealth is created by some tiny, unknowable, fraction of all stocks, so we better own every single one of them or else we'll miss out. FOMO is real. Advisers will either argue the point directly to me, or they'll say their clients care about this."
GMAM on Brent's Comment: It's true that exact replication of the S&P 500 means owning all 500 stocks, and yes, by not owning every stock, you could miss out on some upside—or downside. However, Compact DI’s approach focuses on capturing the core drivers of the index’s performance through a more selective methodology. Rather than spreading investments thin across every single stock, including those with negligible impact, Compact DI emphasizes high-impact holdings that deliver comparable performance.
The goal isn’t to eliminate every potential "omission error," but to create a more efficient, manageable portfolio that balances exposure to key performers while avoiding the dilution that comes from holding hundreds of smaller, less relevant positions. In the long run, this often results in a portfolio with strong alignment to the index without unnecessary complexity or FOMO-driven decision-making.
- to be continued