Exchange traded funds are doing a better job of sticking close to their indexes. Tracking error has been on the decline, according to a recent report.
“As a result of lower tracking error in 2011, 53% of ETFs exhibited tracking error less than or equal to their expense ratios,”Morgan Stanley said. “This is a constructive development for ETFs.” [ETFs and Tracking Error]
Tracking error within the U.S. ETF market has improved 30% over the past year. Morgan Stanley found that only one in 11 ETFs has tracking error of more than 1%, reports Cinthia Murphy for Index Universe.
Tracking error is the divergence between price behavior of a position in a portfolio and the actual price behavior within the benchmark. An ETF that did not perform as expected by the provider ends up creating an unexpected profit or loss, explains Investopedia. [Does it Matter Who Manages My ETF?]
On average, tracking error among the 700 ETFs surveyed in 2011 averaged about 52 basis points at the end of 2011, about 22 basis points lower than the 2010 average.
Tracking error is an important measure of how well an ETF is replicating its benchmark, and this has become more critical as active management within the industry is becoming a more realistic alternative. [5 Things to Consider When Choosing ETFs]
Furthermore, investors may not be aware that expense ratios and management fees are counted as part of tracking error and it can be the most dominant source of this problem. This also explains why some of the larger U.S. equity-linked ETFs, those that track a broad, major index, have some of the lower expense ratios in the business.
Tisha Guerrero contributed to this article.