When it comes to trading exchange traded funds, costs matter. Looking beyond explicit costs, such as commission fees and the expense ratio, people should be aware of the implicit costs as well.
“We think it’s a good measure of how the portfolio is managed and gives an indication of how much misfit risk you’re taking, relative to the underlying portfolio,” Joel Dickson, a senior investment strategist in The Vanguard Group Inc.’s Investment Strategy Group, said in the article.
In a perfect world, investors would assume that a passive ETF would reflect the returns of its underlying index, sans the expense ratio. However, this is not always how it plays out.
According to Morgan Stanley, the average ETF had a tracking error – the divergence between the ETF’s performance to that of the underlying index – of 0.59% in 2012, up from 0.52% in 2011. Additionally, only 39% of ETFs had a tracking error less than their expense ratio in 2012, down from 53% in 2011.