Although rarely considered by the average investor, tracking errors can have an unexpected material effect on an investor's returns. It is important to investigate this aspect of any ETF index fund before committing any money to it.
The goal of an ETF index fund is to track a specific market index, often referred to as the fund's target index. The difference between the returns of the index fund and the target index is known as a fund's tracking error.
Most of the time, the tracking error of an index fund is small, perhaps only a few tenths of one percent. However, a variety of factors can sometimes conspire to open a gap of several percentage points between the index fund and its target index. In order to avoid such an unwelcome surprise, index investors should understand how these gaps may develop.
key takeaways
- The difference between the returns of the index fund and its benchmark index is known as a fund's tracking error.
- SEC diversification rules, fund fees, and securities lending can all cause tracking errors.
- Tracking errors tend to be small, but they can still adversely affect your returns.
- Looking at metrics such as a fund's beta and R-squared can give a sense of how prone it is to tracking error.
What Causes Tracking Errors?
Running an ETF index fund might seem like a simple job, but it can actually be quite difficult. ETF index fund managers often employ complex strategies in order to track their target index in real-time, with fewer costs and greater accuracy than their competitors.
Many market indexes are market-capitalization-weighted. This means that the amount of each security held in the index fluctuates, according to the ratio of its market capitalization against the total market capitalization of all securities in the index. Since market capitalization is market price times shares outstanding, fluctuations in the price of securities cause the composition of these indexes to change constantly.
An index fund 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, whenever an investor buys or sells the ETF index fund, 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. In addition, trades are often executed with slightly different timing, depending on the speed of the exchange and the trading volume in each security.
Types of Tracking Errors
A number of different factors can cause or contribute to tracking error.
Diversification Rules
Securities regulations in the United Statesrequire that ETFs not hold more than 25% of their portfolios in any one stock. This rule creates a problem for specialized funds seeking to replicate the returns of particular industries or sectors. Truly replicating some industry indexes can require holding more than a quarter of the fund in certain stocks. In this case, the fund cannot legally replicate the actual index in full, so a tracking error is very likely to occur.
Fund Management and Trading Fees
Fund management and trading fees are often cited as the largest contributor to tracking error. It is easy to see that even if a given fund tracks the index perfectly, it will still underperform that index by the amount of the fees that are deducted from a fund's returns. Similarly, the more a fund trades securities in the market, the more trading fees it will accumulate, reducing returns.
Securities Lending
Securities lending occurs primarily so that other market participants can take a short position in a stock. In order to sell the stock short, one must first borrow it from someone else. Usually, stocks are borrowed from large institutional fund managers, such as those that run ETF index funds. Managers who participate in securities lending can generate additional returns for investors by charging interest on the borrowed stock. The lending fund still maintains its ownership rights to the stock, including dividends. However, the fees generated create additional returns for investors above what the index would realize.
Often, investors are advised to simply buy the index fund with the lowest fees, but this may not always be advantageous if the fund does not track its index as well as expected.
Spotting Tracking Errors
The key is for investors to understand what they are buying. Make sure that the ETF index fund you are considering does a good job of tracking its index. Key metrics to look for here are the fund's R-squared and beta. R-squared is a statistical measure that indicates how well the index fund's price movements correlate with its benchmark index. The closer the R-squared is to one, the closer the index fund's ups and downs match those of the benchmark.
You will also want to ensure that the fund's beta is very close 1.0, which means its performance moves in sync with the target index. If the fund and the target index are both monitored with respect to the broader market, they should have nearly the same beta. In either case, the objective is to ensure the fund and the target index exhibit about the same risk profile.
Finally, a visual inspection of the fund's returns versus its benchmark index is a good sanity check on the statistics. Be sure to look at different periods to make sure the index fund tracks the index well over both short-term fluctuations and long-term trends.
The Bottom Line
By doing the simple homework suggested above, you can make sure that an ETF index fund tracks its target index as advertised, and you will stand a good chance of avoiding a tracking error that might adversely affect your returns in the future.
FAQs
The difference between the returns of the index fund and its benchmark index is known as a fund's tracking error. SEC diversification rules, fund fees, and securities lending can all cause tracking errors. Tracking errors tend to be small, but they can still adversely affect your returns.
Why is there a tracking error in an ETF? ›
That's because a number of factors prevent the ETF from perfectly mimicking its index. ETF returns don't always trail their index though; tracking difference can be small or large, positive or negative. Tracking error is a related but distinct metric. Tracking error is about variability rather than performance.
How much tracking error is acceptable? ›
In an ideal case scenario, an index fund must have a tracking error of zero when comparing performance to its benchmark. But in reality, index funds lean towards the 1%, -2% range.
Do actively managed ETFs have tracking error? ›
Active managers also experience tracking error for additional reasons: (1) Security selection – even active managers who control benchmark risk may hold positions that are not part of the benchmark; (2) Factor tilts – active managers may implement biases toward certain factors such as value, small cap and sector over-/ ...
Do ETFs guarantee returns? ›
ETFs attempt to track the performance of a specific index - such as the S&P 500 - as closely as possible. Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed.
Which ETF has the highest tracking error? ›
Sector, international, and dividend ETFs tend to have higher absolute tracking errors; broad-based equity and bond ETFs tend to have lower ones. Management expense ratios (MER) are the most prominent cause of tracking error and there tends to be a direct correlation between the size of the MER and tracking error.
Is tracking error good or bad? ›
There is no such thing as a “typical” or “appropriate” amount of tracking error. The acceptable level of tracking error is determined by each investor. Tracking error is neither good, nor bad.
What are the disadvantages of tracking error? ›
Limitations of Tracking Error
Historical Perspective: Tracking error is based on historical data and may not accurately predict future performance. Market conditions and the investment manager's approach can change over time. Benchmark Selection: The choice of the benchmark can significantly impact tracking error.
What does tracking error tell you? ›
Tracking error is measured as the standard deviation of excess returns over time. It's an indicator of how consistently close or wide an index ETF's performance is relative to its benchmark. For investors using indexed products, any uncertainty around performance adds uncertainty costs.
Which index fund has the lowest tracking error? ›
It's calculated in percentage terms. Among large cap funds, Navi Nifty 50 Index Fund has the lowest tracking error of 0.01% among large cap index funds followed by Navi Nifty Next 50 Index Fund with tracking error of 0.02%. In the midcap space, Navi Nifty Midcap 150 Index Fund has the lowest tracking error of 0.01%.
Passive fund managers aim for a low Tracking Error. Lower Tracking Error means that the fund tends to hew pretty close to the index in terms of its performance. A higher one means that the fund is all over the place and probably doing something that's quite different from the index.
What percentage of ETFs are actively managed? ›
In 2022, actively managed ETFs accounted for about 15 percent of global net inflows in ETFs. By March 2023, that number had grown to 25 percent. This increase in popularity of actively managed ETFs can be explained by changing supply and demand dynamics.
Do active ETFs outperform? ›
Additionally, the active management approach means that investors are reliant on the expertise of portfolio managers, and there's no guarantee of outperformance. Some active ETFs may underperform or incur losses when passive benchmarking EFTs may achieve gains.
Has an ETF ever gone to zero? ›
Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.
Why is ETF not a good investment? ›
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
What happens if an ETF goes bust? ›
If you own ETF shares, you will receive cash equivalent to the value of your holding on the day of liquidation (not the value on the last day of trading).
What factors contribute to tracking error in inverse or leveraged ETFs? ›
Swaps on indexes and ETFs are designed to track the performances of their underlying indexes or securities. The performance of an ETF may not perfectly track the inverse performance of the index due to expense ratios and other factors, such as the negative effects of rolling futures contracts.
What is the tracking error of a passive ETF? ›
It measures how closely a passive fund has replicated the total return of its benchmark. High tracking difference suggests the fund deviated significantly from the index's return. Tracking error is the standard deviation of the absolute difference between the fund's performance and that of its benchmark.
What does it mean if a fund manager has a positive tracking error? ›
However, the tracking difference of an Index Fund is not always negative. A positive tracking difference means that the Index Fund has outperformed its benchmark.
What is ETF tracking error and expense ratio? ›
Tracking error is the difference between an ETF portfolio's returns and the benchmark or index it was meant to mimic or beat. ETFs and Index funds, much like other mutual fund schemes, incur expenses on cost heads, such as marketing, advertising, office administration, brokerage and so on.
