Why Identical Index Funds Perform Differently

Same index, same holdings, different answer

Two funds track the same index. They hold the same companies in the same weights. One charges 0.07% a year, the other 0.12%. Over five years the cheaper one is behind.

This happens constantly, and it is not an error in the data. A fund's fee is the most visible cost it carries and rarely the largest. The gap between two trackers on one index is decided by plumbing that never appears on a comparison table: what tax the fund pays before you see a penny, how it holds the index, what it earns lending its shares out, and which version of the index it is measured against.

Here is how to read the difference, and where to look for it.

The number you should be comparing

Most people compare fees. The number that actually answers the question is tracking difference: the fund's total return minus the index's total return over the same period. If the index returned 10% and the fund returned 9.9%, the tracking difference is negative 0.1%. That is what the fund cost you, all in.

It gets confused with tracking error, which is a different measurement entirely. Tracking error is the standard deviation of that gap over time. It tells you how consistent the fund's tracking is, not how expensive it was. A fund can have very low tracking error while reliably lagging by half a percent a year.

For a long-term holder, tracking difference is the one that matters. Low tracking error is mainly useful if you are trading around the fund or using it as a precise building block.

The fee sets your expectation. Everything below explains why the outcome usually differs from it.

The costs that sit on top of the fee

A fund's stated ongoing charge is the floor, not the total. Several other frictions push the gap wider:

• Rebalancing and reconstitution. When the index adds or drops a company, every fund tracking it has to trade. Those trades cost money, and if the market anticipates the change, funds often buy at worse prices than the index assumes.

• Cash drag. Money sitting uninvested between a dividend arriving and being reinvested lags a rising index. It helps slightly in a falling one.

• Dividend timing. The index assumes dividends are reinvested the instant they are paid. Real funds receive them, hold them briefly, then reinvest.

• Sampling. Broad indices with thousands of constituents, or holdings in thin markets, are often tracked by holding a representative subset rather than everything. That adds variability.

None of these is large on its own. Together they are usually worth a few basis points a year, and they explain why two funds with identical fees rarely post identical results.

Where the real money goes: withholding tax

This is the layer that most comparisons miss entirely, and it is often bigger than the fee.

When a company pays a dividend to a foreign shareholder, the country it is based in usually taxes that payment at source. The tax comes out before the money reaches the fund. It is deducted at fund level, it is already inside the net asset value you see, and as an individual investor you cannot reclaim it.

The rate depends on the tax treaty between the company's country and the country the fund is domiciled in. Not where you live. Not where the fund is listed. Where the fund is legally established.

The United States withholds 30% on dividends to foreign entities by default. Under the US-Ireland treaty, an Irish-domiciled fund generally has that reduced to 15%. Luxembourg has its own US treaty, but the standard Luxembourg fund vehicle often does not access the reduced rate the way an Irish fund does, and many Luxembourg-domiciled equity funds bear the full statutory rate on US dividends in practice. That detail is structure-specific, so check the fund's annual report rather than assuming either way.

The size of it is easy to work out. Take a US index yielding around 1.3% in dividends. A 15 percentage point difference in withholding is roughly 0.20% of your money every year. At a 2% yield it is closer to 0.30%. Either figure is larger than the entire annual fee on a modern S&P 500 tracker.

How to check in ten seconds: look at the ISIN. Irish-domiciled funds start with IE. Luxembourg funds start with LU. It appears on your broker's instrument page before you place an order, and the fund's key information document states the domicile and the supervising regulator outright.

Why a fund can beat its own index

This is the part that confuses people, and it has a mundane explanation.

Most funds are benchmarked against a net total return version of their index. Net total return indices assume dividends are reinvested after withholding tax at an assumed rate, and for US dividends that assumption is commonly the full statutory rate rather than a treaty rate.

So a fund paying 15% while its benchmark assumes 30% keeps the difference. That advantage can be large enough to cancel the fund's fee, and occasionally to exceed it, which is how a passive fund posts a positive tracking difference against its own index.

Securities lending does the same thing from the other direction. Many funds lend their holdings to short sellers against collateral, collect a fee, and credit most of it back to the fund. The index assumes no lending income. The fund earns some. The gap closes.

A tracker beating its benchmark is almost never skill. It is tax treatment and lending revenue, and both are disclosed in the annual report.

Synthetic funds and the swap exemption

Some funds do not hold the index at all. They enter a total return swap with a bank, which pays them the index return in exchange for a fee.

Under US rules on dividend equivalent payments, swaps written on a qualified index are exempt from the withholding that a physical holder would suffer. The criteria are specific: broadly, the index must be passive, widely used, built on a diverse basket of publicly traded securities, contain at least 25 components, have no single US equity above 15% of the weighting, have no group of five or fewer US equities exceeding 40% combined, and satisfy a dividend yield test relative to the S&P 500. Major index providers publish assessments each year to help funds determine the status of their benchmarks.

For a fund tracking a large US or global index, that can mean receiving the index return gross of dividend withholding, which is a structural edge of roughly the 15 points a physical Irish fund still pays.

Two things to hold onto. First, there is a swap fee that offsets part of the gain, plus collateralised counterparty exposure to the bank on the other side, which physical replication does not carry. Second, and more interesting for the long run, qualification is conditional and reviewed annually. The concentration limits mean an index that becomes dominated by a handful of very large companies could in principle stop qualifying. This advantage is a feature of current tax law, not a permanent property of the fund.

Where you hold it can matter more than which one you buy

For many investors, account placement moves more money than fund selection.

Canada. Article XXI of the Canada-US treaty exempts recognised retirement plans from US withholding on dividends. An RRSP, RRIF or LIRA holding US securities directly, including through a US-listed ETF, receives US dividends with no withholding at all. A TFSA, FHSA or RESP is not covered by that exemption: 15% is withheld, and because the income is not taxable in Canada, no foreign tax credit can ever recover it. A Canadian-listed fund that holds US stocks pays the withholding inside the fund regardless of the account, and a Canadian wrapper holding a US-listed ETF that holds international stocks can create two separate layers of it.

United Kingdom. Any non-UK fund is an offshore fund for HMRC purposes, and that includes every US-domiciled ETF. If the fund does not have Reporting Fund Status, your profit on sale is taxed as an offshore income gain at income tax rates rather than capital gains rates. HMRC publishes a list of funds that hold the status, and most large Irish and Luxembourg UCITS funds are on it. Reporting status carries its own obligation: you declare your share of the fund's reportable income each year even if the fund is accumulating and paid you nothing. That amount is added to your cost base when you sell, so you are not taxed twice, but you have to track it.

Investors outside the US generally. A US-domiciled fund can bring US estate tax exposure on US-situated assets above a low threshold, subject to any treaty in place, and a fund holding non-US stocks inside a US wrapper can suffer withholding twice over. This is a large part of why Irish-domiciled funds dominate for non-US investors.

Differences that are not really differences

Four things that look like tracking gaps and are not:

• Currency of listing is not currency exposure. A fund listed in pounds holding US shares still gives you dollar exposure. Only an explicitly hedged share class changes that, and hedging has its own ongoing cost.

• Accumulating versus distributing changes when and how you receive returns, and your tax treatment, but not the gross return the fund earns.

• The wrong index variant. Price return, net total return and gross total return are three different numbers for the same index. Compare a fund against the gross version and it will always look like it is failing.

• Market price versus NAV. Comparing the traded price rather than net asset value pulls the bid-ask spread into your calculation and makes the fund look worse than it performed.

Checking a fund in five minutes

1. Find the ISIN and note the domicile from the prefix.

2. Read the factsheet for the exact index name, including the variant.

3. Compare the fund's NAV total return against that exact index over one, three and five years. The issuer usually publishes both side by side.

4. Check the annual report for the replication method, whether the fund lends securities, and how much of the lending revenue it keeps.

5. Confirm the fund's tax status for your country and the account you plan to hold it in.

Do this once a year. Nothing here changes fast, and it does not need watching.

The short version

Two funds on one index differ because of what they pay in tax, how they hold the index, what they earn on the side, and which version of the index they are compared against. Check the domicile, check the index variant, compare NAV total return rather than fees, and pay attention to which account you hold it in. That covers almost the entire gap.