Tracking error in exchange traded funds is a factor that should be studied when selecting a fund. This can be a drag on total returns.
“Before we even consider an ETF’s expense ratio, we look at its tracking error. It gives us a more complete picture,” Chuck Simko, a senior portfolio manager at MainStreet Advisors, said in a recent report.
An ETF that does not track its intended benchmark correctly can wind up costing investors more than a fund that is priced higher. Tracking error is a measure of how well, or not so well, an ETF tracks the selected index. Most experienced investors and advisors will consider how well an ETF tracks its benchmark, and gravitate towards those with the lowest tracking error, reports Murray Coleman for The WSJ. This ensures that liquidity will remain in the ETF, too. [Risks to Consider When Investing in ETFs]
“We’ve found that comparing expense ratios should come later in the selection process,” Gene Goldman, who serves as research director at the Los Angeles-based brokerage Cetera Financial Group, with about $20 billion in advisory assets. At first glance, putting tracking error over expenses might sound a bit counterintuitive. As Mr. Goldman notes: “Since raw index returns don’t need to deal with expense ratios, an ETF’s performance in an ideal world should equate to its benchmark return minus its expense ratio.”