While trading any exchange traded fund product, investors will note obvious costs like commission fees and expense ratios, but ETFs come with varying levels of indirect costs, such as tracking error.
Tracking error in index funds is the measure how far the ETF’s price deviates from its underlying net asset value, or NAV, over time, writes Ari I. Weinberg for The Wall Street Journal.
For instance, if an underlying index rose 1% over and an ETF that tracks the index increased 0.9%, the fund is said to have a 0.1 percentage point tracking error.
Nevertheless, ETF investors should note that tracking errors are common because it simply reflects the costs that the index don’t incur, such as the expense ratio. Dan Dolan, a director for ALPS Distributors Inc., which markets the SPDR sutie of ETFs, notes that tracking errors essentially reflect a fund’s expense ratio.
Fund managers, though, may narrow or even close the gap through better managing, portfolio rebalancing, dividend payouts and securities lending.
A narrow tracking error “means that manager is delivering on what’s advertised,” Todd Rosenbluth, ETF analyst at S&P Capital IQ, said in the article.
However, on the other end of the spectrum, tracking errors may widen if the fund holds securities not from the benchmark, due to cost and complications involving the creation and redemption process. [Creations and Redemptions]
Additionally, ETFs that hold non-U.S. securities exhibit tracking errors because the underlying indices are closed during normal U.S. trading hours. However, various fund sponsors use varied approaches to setting their NAVs.
“If the benchmark index isn’t also adjusting local closing prices to reflect the impact of current market conditions at 4 p.m., then there can be a difference in the index returns when compared with the fund’s returns,” Rob Haddad, a director at Interactive Data Corp., said int he article. “This differential can get amplified, depending on the day.”
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.