The firm found that the average tracking error and the magnitude has been ticking higher as the ETF universe expands into more-exotic investments.
Industry experts attribute tracking error to how ETFs are constructed, or “optimizing.” Rene Casis, director in the iShares Index Equity Portfolio Management Group, explained that ETFs employ a type of sampling technique that only picks certain stocks from an index. He argues that fully replicating an index is not always practical, especially in less liquid markets and hard to access areas, such as the emerging markets.
However, some fund sponsors have also tried to mitigate the effects of tracking errors through securities lending by loaning out underlying shares to borrowers for a profit, which could even help an ETF outperform its expense ratio. [ETF Securities Lending in Focus on iShares Suit]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.