Exchange traded funds (ETFs) are designed to follow indexes, but they can’t always do it precisely. When they deviate, it’s called a tracking error. This is the difference in performance between the index and the ETF itself, reports Jesse Emspak for Investor’s Business Daily. ETFs that track less-liquid markets or securities tend to diverge from the underlying securities. Other times, tracking error strikes when a provider attempts to optimize rather than closely track an index. An example of this is ProShares Ultra Semiconductor (USD), which seeks a return of 200% on the daily movement of the Dow Jones U.S. Semiconductor Index.
Another major reason tracking errors occur is because many funds have maximum allocations to a single security, around 25%. Securities within a fund that make up 5% of assets can’t add up to more than 50%. So these limits make it so that even if an index has a stock that makes up a large portion of it, the ETF can’t mirror that and the provider has to adjust it. For example, The Dow Jones U.S. Telecommunications Fund (IYZ) follows an index that has 46% of its value in AT&T (T) and 22% in Verizon (VZ), but the ETF has 17% in AT&T and 14% in Verizon.
Also, tracking errors aren’t always a negative thing. The iShares MSCI Mexico Index (EWW) outperformed the index because it had more weight in smaller-cap stocks than the index did. This is an example of when ETFs can be considered more diversified than the industries or markets that they represent.
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