Tracking error is a measure of how well an investment is performing relative to the selected benchmark. It does not indicate if a portfolio is outperforming or underperforming its benchmark. [Four ETF Cost Factors to Weigh Beyond Expense Ratios]
An ETF must execute trades in such a way as to hold hundreds or thousands of securities precisely in proportion to their weighting in the constantly changing target index. In theory, when an investor buys or sells the ETF, trades for all of these different securities must be executed simultaneously at the current price. This is not the reality. Although these trades are automated, the fund’s buy and sell transactions may be large enough to slightly change the prices of the securities it is trading. This is when tracking error can occur. [Low Fees are Important but Consider Other Factor When Picking ETFs]
Themes such as volatility patterns or return comparisons over a period of time are common ways investors measure tracking error. To decide which method is right for you, it is important to do the necessary homework. Many investors measure tracing error differently and can come to different conclusions about the same ETF.
Tisha Guerrero contributed to this article.