A Case Study in Mismatched Fund Returns - Why do a fund's returns sometimes differ from its underlying index? A longstanding legal principle holds the key.

 

A Case Study in Mismatched Fund Returns

Why Do a Fund’s Returns Sometimes Differ from Its Underlying Index? A Longstanding Legal Principle Holds the Key

By Steven Orlowski, CFP, CNPR

In the world of investing, index funds are often promoted for their simplicity, cost-effectiveness, and transparency. The pitch is compelling: by mirroring the performance of a benchmark index like the S&P 500, investors can achieve broad market exposure without the risks and costs associated with active management.

However, a curious phenomenon sometimes puzzles investors. Even when a fund is designed to track an index, its returns don’t always match the performance of that index. The discrepancies are usually small—fractions of a percent—but occasionally they are large enough to raise eyebrows. Why does this happen?

At first glance, the mismatch might seem like an operational error or hidden fee structure. But in many cases, the answer lies in a lesser-known but longstanding legal and accounting principle: the distinction between price return and total return, and the rules that govern fund accounting.

Price Return vs. Total Return: A Critical Difference

Indexes come in two flavors: price return and total return. The price return index tracks only the changes in market prices of its constituent securities. The total return index, on the other hand, includes both price changes and the reinvestment of dividends or interest income.

Most major indexes, such as the S&P 500 or the MSCI EAFE, publish both versions. The media usually reports the price return version, while mutual funds and ETFs typically aim to track the total return. This creates the first potential source of confusion. A fund’s performance may appear to lag the index simply because the investor is comparing the fund’s total return with the index’s price return.

Structural Drag: The Cost of Doing Business

Even when a fund correctly tracks the total return version of an index, several factors can create slippage:

1. Expense Ratios: Every fund charges an expense ratio to cover management and administrative costs. While low-cost index funds may charge as little as 0.03%, that fee still eats into returns.

2. Cash Drag: Funds are often required to keep a small portion of their portfolio in cash to meet redemptions. During a bull market, that uninvested cash can act as a drag on performance.

3. Dividend Timing: Indexes assume immediate reinvestment of dividends. Real-world funds must first receive the dividend, then reinvest it, often with a slight delay. This timing mismatch can cause small discrepancies in reported returns.

4. Taxes and Withholding: In international funds, foreign tax withholding can further reduce actual income compared to index assumptions, especially in jurisdictions where treaties don’t eliminate the withholding entirely.

The Legal Principle: Substance Over Form

Beyond the mechanical and accounting details, there is a deeper legal issue that frames how fund returns are calculated: the principle of substance over form.

Originating in tax and corporate law, this principle holds that the true nature of a transaction or financial structure—its economic reality—should take precedence over its legal form or superficial appearance. In the context of fund performance, it means that even if a fund is legally structured to “track” an index, its actual return is what matters to regulators, auditors, and investors.

The principle also governs how dividends and interest are accounted for. For example, even if a dividend has been declared by an index component company, a fund does not count it as income until it is received. This can lead to timing mismatches, especially around the end of reporting periods. Auditors and regulators follow the actual flow of money—not what the index “imputes”—and require fund returns to reflect reality, not hypothetical reinvestments.

A Real-World Case Study

Consider an ETF that tracks the S&P 500 Total Return Index. During a particular quarter, the index rises 5.2%, while the fund reports a return of 4.9%. An investor might ask: where did the missing 0.3% go?

Upon inspection, we find:

• The fund’s expense ratio is 0.05% for the quarter.

• The fund held 1.5% in cash to meet redemptions.

• There was a two-day lag in reinvesting dividends, during which the market rose.

• Several foreign-domiciled companies in the index issued dividends subject to U.S. withholding tax.

Each factor alone appears minor, but together they can compound into a noticeable return gap. This is not mismanagement—it is the unavoidable friction of tracking an idealized benchmark in the real world.

Implications for Investors

For most long-term investors, these discrepancies are negligible and do not alter the fundamental appeal of index funds. However, for institutional investors, performance analysts, or legal professionals, understanding these return mismatches is critical.

It reminds us that indexes are theoretical constructs, while funds are real financial vehicles, operating under legal, regulatory, and operational constraints. The longstanding legal principle of “substance over form” ensures that funds represent true economic outcomes—not just idealized models.

Conclusion

When fund returns don’t match their benchmarks, it’s rarely a mistake. Instead, it's usually the result of structural realities, accounting rules, and legal principles designed to promote transparency and accuracy. For informed investors, these gaps are not red flags but reminders: while funds aim to mimic indexes, they are ultimately grounded in the real, regulated, and occasionally messy world of finance.