Index design and implications for index tracking

Tracking error in index fund performance is unavoidable. It arises because the underlying index is measured as a paper portfolio, and it is assumed perfect replication can be achieved instantaneously and without cost. Tracking error has two components: exogenous tracking error (the result of index rules and maintenance procedures applied to the underlying index) and endogenous tracking error (the result of the individual activities of index managers managing open-end passive funds). An examination of a sample of S&P 500 index mutual funds upon changes to the Index Divisor identifies a number of exogenous factors that are important determinants of tracking error for S&P 500 index funds.