While looking into exchange traded funds (ETFs), a potential investor may have noticed some “tracking errors” that occur in comparing the benchmark index with an ETF. But don’t let this discourage you from considering a useful investment tool.

The market price of an ETF should closely match its net asset value (NAV), which should approximately reflect the performance of the underlying index, remarks Kyle Waller for IndexUniverse.

But at times, tracking errors manifest itself when there is a disparity between the ETF’s NAV and the index’s value. It is seen as how well an ETF issuer is achieving its objective of reproducing the index’s performance. The errors could be because of the implicit costs of investing in an ETF and sometimes it can be a more important cost in comparison to the explicit ETF expense ratio.

In areas like emerging markets, tracking errors may usually occur as a result of indexes with stocks that could be illiquid or hard to invest in. Emerging market ETFs are international investment tools that may trade during hours different from underlying holdings, and this new input of information at varying hours could account for daily tracking errors in these types of ETFs.

Another way to affect the way an ETF tracks its index is management through optimization. Optimization is done when, for any number of reasons, replication is not possible: it would be too expensive to buy the index, there are limits on the number of shares a fund can own, the index is just too big and so on. Still, a more optimized ETF has a higher risk of that fund not tracking the index in the future. Which of these ETFs are right for you? It’s a matter of preference.

  • iShares MSCI Emerging Markets Index (EEM): up 2.6% year-to-date

ETF EEM performance

  • Vanguard Emerging Markets Stock ETF (VWO): up 3.6% year-to-date

ETF VWO performance

Disclosure: Tom Lydon has clients with shares in EEM.

Max Chen contributed to this article.

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.