While trading any exchange traded fund product, investors will note obvious costs like commission fees and expense ratios, but ETFs come with varying levels of indirect costs, such as tracking error.
Tracking error in index funds is the measure how far the ETF’s price deviates from its underlying net asset value, or NAV, over time, writes Ari I. Weinberg for The Wall Street Journal.
For instance, if an underlying index rose 1% over and an ETF that tracks the index increased 0.9%, the fund is said to have a 0.1 percentage point tracking error.
Nevertheless, ETF investors should note that tracking errors are common because it simply reflects the costs that the index don’t incur, such as the expense ratio. Dan Dolan, a director for ALPS Distributors Inc., which markets the SPDR sutie of ETFs, notes that tracking errors essentially reflect a fund’s expense ratio.
Fund managers, though, may narrow or even close the gap through better managing, portfolio rebalancing, dividend payouts and securities lending.
A narrow tracking error “means that manager is delivering on what’s advertised,” Todd Rosenbluth, ETF analyst at S&P Capital IQ, said in the article.