Hay has been made about exchange traded fund (ETF) tracking error, but a recent analysis shows that it’s far from a big problem.

Deutsche Bank’s ETF analyst Christos Costandinides has issued a report about the causes of tracking error in 59 equity ETFs listed in Europe. He concludes that “any tracking error of less than 50 basis points [0.50%] in a year may not be worth worrying about. When it starts to inch up toward 100 basis points [1%], then I would be concerned. Above 100, I would be more alarmed.”

Sophia Greene for Financial Times reports that if tracking error is over 2%, it is not an index fund anymore. Investors need to understand the sources of the tracking error, however, before making a judgment on whether the ETF manager is doing the job to the best of their ability, Costandinides says. [Contango: Another Issue.]

Tracking error is when a fund’s performance veers from the benchmark index that it is supposed to reflect.

Other causes of tracking error include:

  • Fund fees. Even ETFs that track their benchmarks with precision will underperform once fees are factored in. ETFs that track the same index but have different fees will exhibit different performance.
  • Illiquid holdings. This is more often a problem with emerging market ETFs, reports Jessica Mead with City AM.
  • Index optimization. Sometimes it’s necessary to optimize and index because owning all the securities in the benchmark would be cost-prohibitive. Statistical portfolio sampling may not always work out as planned. [Why More ETFs Had Tracking Error In 2009.]

Tisha Guerrero 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.

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