The majority of exchange traded funds simply act as passive investment vehicles designed to replicate the return of a benchmark index, but there are times that the ETF may not perfectly reflect the performance of the underlying index in what is best known as tracking errors.
“Tracking difference is critically important when selecting passive ETFs,” Anaelle Ubaldino, a quantitative financial adviser at Koris International, a French investment advisory firm linked to TrackInsight, told the Financial Times. “It paints the full picture of how well an ETF tracks its index and should thus be investors’ preferred metric for ETF comparison.”
The tracking errors can occur through a number of instances. For example, when a target index is rebalanced, such as during the quarterly house cleaning, an ETF will need to buy and sell securities to maintain its accurate index replication, which will incur transaction costs.
“This will cause a drag on investors’ returns since the index performance does not reflect these costs,” Ubaldino said.
More complex ETF strategies, like smart beta or factor-based indices, may also trade more often, which would in turn incur greater transaction costs.
Furthermore, tracking errors can occur between the holdings of the ETF and its target index. Some ETFs don’t perfectly reflect a benchmark index but instead, take a “sampling” approach where the ETF would only take the best guess representation of an index that may track thousands of individual securities.
Different timezones may also affect tracking capabilities since some benchmarks in the other part of the world may be closed during normal U.S. trading hours.
“When the index holdings are spread across time zones and currencies, or when they are not readily available to trade on the secondary market, it is harder for the ETF issuer to replicate the index accurately,” Ubaldino added.
Cash can also affect tracking errors as yield generating strategies would accumulate cash hoards and then they would have to reinvest the coupon payments or dividends
For more information on ETFs, visit our ETF 101 category.