The Causes of Tracking Error In ETFs | ETF Trends

Tracking errors, at least some minuscule discrepancies, are something that can be a necessary evil in exchange traded fund (ETFs). The errors were even more noticeable in volatile trading during the financial crisis.

Tracking error is when a fund’s performance veers from the benchmark index that it is supposed to reflect, writes Sam Mamudi for The Wall Street Journal. The problem is magnified for funds in smaller segments of the market, whose stock holdings are less liquid and, at times, more volatile than the broader market. [Tracking errors: what it is and how it happens.]

ETFs that track the same benchmark also have varying results. For instance, the iShares MSCI Emerging Markets Index (NYSEArca: EEM) and the Vanguard Emerging Markets Stock (NYSEArca: VWO) both follow the MSCI Emerging Markets Index, but VWO gained about 76% while EEM increased around 72%. The index was up 78.5%. [Things that determine an ETF’s performance.]

One reason for the disparity is because of costs. VWO has a lower expense ratio and the savings are passed onto the investor as higher returns. Another reason is because of different fund management styles. For example, VWO tries to fully match the index, with more than 800 holdings, while EEM is more selective, with around 400 holdings.

Differences in performance are also seen among similar ETFs that use different indexes. For example, small-cap growth ETFs have three main choices: the iShares S&P SmallCap 600 Growth (NYSEArca: IJT), SPDR Dow Jones Small Cap Growth (NYSEArca: DSG) and Vanguard Small Cap Growth ETF (NYSEArca: VBK). IJT, which follows the S&P Small Cap 600/Citigroup Growth Index, had a total return of 28.8% in 2009; DSG, which tracks the Dow Jones Small Cap Growth Total Stock Market Index, was up 47%; and VBK, which reflects the MSCI U.S. Small Cap Growth Index, increased 42%.

For more information on ETFs, visit our ETF 101 category.

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.