Vanguard small cap index funds tracking error

Tracking error is the ultimate measure of judging an index fund manager's performance. Since an index manager does not engage in security selection with an index fund, it is the manager's transactional skill which distinguishes performance. How well the manager uses index futures, cross trading, block trading, and manages trading around index reconstitution determines how close the manager can track the index benchmark. Vanguard, in its attempt to closely track index returns, utilizes the following trading policies:
 * Rebalance each portfolio every business day to eliminate or reduce risk factor differences between funds and indexes.
 * Strive to be 100% invested at all times, using futures and ETFs to equitize cash for full investment, with no cash drag and no leverage.
 * Trade carefully, matching execution prices to fund share valuation.
 * Leverage cross-trading opportunities with Vanguard's many other investment funds, reducing or eliminating commissions and transaction charges.
 * Maintain tight controls over commissions, bid-ask spreads, and market impact. For example, our proprietary portfolio systems establish minimum trade sizes to control transaction costs.

Tracking error
Table 1. provides the long term average tracking errors for Vanguard's small cap index funds. (Please note we have data going back to 1993 for the Small Cap Index fund; the fund transitioned to index investing in 1989). With the increased availability of admiral share classes (reduced minimum investment $10,000) we provide tracking error data for both investor and admiral shares in the fund. The lower expense admiral shares produce tighter tracking of benchmark returns.

We should note that the historical tracking errors are less than the expense ratios for the funds, meaning that the index manager has provided added returns to fund investors through transactional efficiency. Detailed annual tracking error data (along with additional statistical measurement of fund returns) are provided in the footnote tables.

Benchmark index changes
The Vanguard Small Cap, Small Growth and Small Value index funds have changed benchmark tracking indices over their history. The Small cap fund changed from Russell to MSCI indices; the two style funds shifted from S&P indices to MSCI indices. Table 2 provides a breakdown of tracking error to each benchmark index. Since the 2003 transition year provided a rather large one-time positive tracking error over the split index tracking indices for both the small growth and small value funds, we have isolated the 2003 returns in the table. The table also provides the tracking errors since the inception of admiral shares in each fund.

{| border="1" style="text-align:center; border-collapse: collapse;" cellpadding="3"