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.”
Tracking error is a measure of how well an investment is performing relative to the selected benchmark. It does not indicate if a portfolio is outperforming or underperforming its benchmark. [Four ETF Cost Factors to Weigh Beyond Expense Ratios]
An ETF must execute trades in such a way as to hold hundreds or thousands of securities precisely in proportion to their weighting in the constantly changing target index. In theory, when an investor buys or sells the ETF, trades for all of these different securities must be executed simultaneously at the current price. This is not the reality. Although these trades are automated, the fund’s buy and sell transactions may be large enough to slightly change the prices of the securities it is trading. This is when tracking error can occur. [Low Fees are Important but Consider Other Factor When Picking ETFs]
Themes such as volatility patterns or return comparisons over a period of time are common ways investors measure tracking error. To decide which method is right for you, it is important to do the necessary homework. Many investors measure tracing error differently and can come to different conclusions about the same ETF.
Tisha Guerrero contributed to this article.