Exchange traded funds (ETFs) are expected to mirror the returns of an index minus the expenses, but sometimes they get off track. Shirley Won for ReportonBusiness says anything greater or less than the index means there is a tracking error.
Most ETF providers agree that a small amount of tracking error beyond management expense ratio (MER) is unavoidable depending on the make up of the investment and some indexes are tougher to mimic. One example is cash dividends, which can create a slight drag before it is paid out by an ETF. Optimizing a portfolio can also be a culprit for tracking error. When they use fewer holdings to approximate an index in an attempt to reduce trading costs, it is difficult to trade stocks in certain foreign countries.
There are numerous reasons for tracking error, and as an ETF investor it is important to be aware of this deviation. Every ETF has different factors playing into reasons for error, so it is wise to check performance and look into holdings.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.