Most exchange traded funds are based on an underlying benchmark, but as the result of the way the funds are constructed, the investments may not always perfectly reflect the benchmark Index.
Tracking error is the divergence between the price of the ETF and the overall price of a benchmark Index, which would generate an unintended profit or loss as a result. [What is an ETF?]
ETFs usually make investments that vary from the original index. For instance, some ETFs would use a sampling technique to select a group of securities from an Index’s total components.
Additionally, ETFs may allocate a small percentage of assets into futures or derivatives to gain its necessary exposure.
ETF investors may notice two types of tracking errors: premium and discount. If a fund is priced above its net asset value, it is said to be trading at a premium. Oppositely, if the fund is priced below its net asset value, it is said to be trading at a discount. Potential investors should look for premiums as it indirectly eats away at potential gains. [Five Things You Need to Know About Trading ETFs]
Typically, if a premium or discount occurs, a market maker, or Authorized Participant, will use the opportunity to arbitrage the difference away, pocketing a quick profit and helping to return the ETF price closer to its NAV. [Three Things to Remember About ETF Premiums and Discounts]
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.