Most exchange traded funds (ETFs) track an index, but replication of the underlying index isn’t always perfect. There are 10 common events that can lead to tracking error.

While ETFs aim to track their underlying indexes as closely as they can, it’s noted on fact sheets that they “seek to replicate, to the extent possible.” The subtext is that while they try to avoid this scenario, a host of events could prevent this from happening. And while the word “error” can have negative connotations, keep in mind that error can work in your favor.

Larry MacDonald for Investopedia reports that the average tracking error for U.S.-listed ETFs was 0.52% in 2008; in some cases, ETFs exceeded their benchmarks and this is factored into the percentage. Sector, international and dividend ETFs tend to have higher absolute tracking errors; broad-based funds tend to have the lowest. What are some of the reasons it happens? MacDonald has a comprehensive list:

  • Net Asset Value: When there are premiums and discounts to net asset value (NAV), this means that investors are bidding above or below the net asset value of the basket of stocks. While rare, premiums and discounts as high as 5% have been known to occur, particularly for thinly-traded ETFs.
  • Optimization: When there are thinly-traded stocks in the benchmark index, the ETF provider can’t buy them influencing their prices a great deal, so they use a sample of only the most liquid stocks.
  • Diversification Constraints: There are regulations set upon ETFs and mutual funds, and of note are two diversification requirements: no more than 25% of assets are permitted in any one security and securities with more than a 5% share are restricted to 50% of the fund.
  • Cash Drag: ETFs have cash holdings, which can accumulate at intervals because of dividend payments, overnight balances and trading activity. The lag between receiving and reinvesting the cash can lead to differences between the index and the ETF. This is only a small contribution to tracking error.
  • Index Changes: Indexes do get updated and when they do, some tracking error may occur if the ETF isn’t able to update.
  • Capital Gains Distributions: On an after-tax basis, distributions can lead to differing performance between the ETF and the index.
  • Securities Lending: Some providers can mitigate the impact of tracking error by lending securities to hedge funds or for short selling; the fees from this are then used to lower the error, if necessary.
  • Currency Hedging: Factors affecting hedging costs are market volatility and interest-rate differentials, which impact the pricing and performance of forward contracts.
  • Futures Roll: Rolling futures contracts (in which a provider sells an expiring contract and uses the money to buy the next contract) is repeated monthly. If contango is in place, there will be a loss. In backwardation, the tracking error will be positive. (What contango means).
  • Constant Leverage: Leveraged and inverse ETFs use swaps, forwards and futures to replicate on a daily basis two or three times the direct or inverse return of a benchmark index. Since they rebalance daily, it can over time lead to tracking error. But on a daily basis, these ETFs perform as they should. (ETF Trends’ guide to leveraged and inverse ETFs).

    More on tracking error can be found here. For more stories about ETFs, visit our ETF 101 category.

    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.