Tracking error can end up being a hidden cost when it comes to exchange traded fund investing. This fact is enough reason to pay attention to the benchmark that a desired ETF is tracking.

“Most ETFs are designed to track the performance of an underlying index of assets. Tracking error is the degree to which an ETF fails to do so. Put another way, tracking error is the difference — positive or negative — in total return between an ETF and its benchmark,” Peter Carbonara wrote in a recent Barron’s article. [How to Keep Tabs on ETF Tracking Error]

Also, tracking error can be used as a hallmark of the quality of the portfolio management process, says Joel Dickson, head of Vanguard’s equity group. Simply put, the tracking error is the difference between the return an investor receives and that of the benchmark they were trying to imitate. [ETFs Tracking the Same Index Can Perform Differently]

In general, the tracking error of an ETF to its index is usually small, like one-tenth of a percent. A gap in tracking error occurs when trades of all the stocks held in an ETF are bought or sold simultaneously and some of the securities get thrown off of their proportion to the weighting they represent within the target index.

The good news is that most U.S.-listed ETFs have low tracking error, and the occurrence is on the decline. On average, the tracking error in the aforementioned funds is about 52 basis points, down from 73 in 2009, according to a Morgan Stanley Smith Barney analysis. [ETF Tracking Error Declines]

The amount of tracking error can be linked to the size and liquidity of the index. The bigger and more liquid the indices, the better an ETF tracks it. For those indices that are illiquid, tracing error becomes a problem. An example is commodity indices, since so many derivatives and futures contracts are involved, tracking the same benchmark is complicated.

The factors that can add to tracking error include:

  • Fees and Expenses: Fees are taken away from a funds total return, so the better the ETF is tracking the index, the less expensive it tends to be. Even an ETF that tracks its benchmark perfect will still have tracking error equal to its expense ratio.
  • Index Changes: Transactions such as adding or dropping shares or re-balancing can indirectly effect cost. While these actions cost nothing and do not cause tracking error, the holdings adjust to match the index, creating the buying and selling that will become hidden fees.
  • Diversification Rules: The same rule applies to ETFs as does mutual funds-No more than 25% of total assets can be in a single security, and securities with more than a 5% share cannot exceed 50% of the fund. Thus, managers have to use optimization techniques that can lead to further tracking error.

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.

Subscribe to our free daily newsletters!
Please enter your email address to subscribe to ETF Trends' newsletters featuring latest news and educational events.