[This article appears in our January 2017 issue of ETF Report.]
Although ETFs attempt to replicate whatever index they follow, it’s not possible for the fund’s returns to completely match the index’s returns at all times.
The variability between the portfolio returns and the benchmark returns is called tracking error, and for math fans out there, tracking error is calculated as the standard deviation of daily return differences between the two.
The greater the volatility, the less consistent the ETF is in replicating the index.
There are several reasons why tracking error occurs, and factors that cause variability in returns are known as tracking difference. The biggest indicator of future tracking difference is the total expense ratio. But other factors contribute to tracking difference and make up how much tracking error an ETF experiences.
When an index rebalances its holdings to add or remove a company, the ETF must follow by buying or selling the underlying securities, and that incurs costs. The transactions and the time it takes to complete those can be issues.
Some funds can’t hold every company in an index, especially if the index contains thousands of securities, so it may just have a sample of the securities. How a fund deals with cash, such as when it received a dividend, may cause a drag. If a fund lends the securities they own, it could help with the fund’s performance, and cause some variability in returns, too.
While tracking error sounds like it could be a problem, whether it matters to an investor depends on how the person is using the ETF.
“For active traders and those using ETFs as a hedge it may [matter], but for most buy-and-hold investors, I think it gets too much attention,” said Michael Krause, president of AltaVista Research.
Krause said investors should focus on a fund’s holdings and returns more than on tracking error, as the performance of any fund—whether it has positive or negative returns—will more than offset any volatility produced by tracking error.
“So you want to focus on whether the underlying holdings in aggregate represent a good investment. For example, if you rode a financial sector ETF all the way down during the financial crisis, the fact that the fund may have tracked its index almost perfectly wouldn’t have been much consolation to you,” he said.
Todd Rosenbluth, director of ETF and mutual fund research at CFRA, concurred. What’s more important is that investors look at what’s inside the index to get an understanding of how it performs, he says.
Another consideration is that tracking error is a factor for market-cap-weighted ETFs, like the S&P 500 Index or similar indexes. In an era of smart beta and factor investing, it may not matter, adds Rosenbluth.
“Increasingly, as smart beta and factor-based products and propriety-index-based products come to market, the value of how well an ETF tracks its index is less meaningful to us than if the index itself is worth tracking,” he noted.