Some ETFs really do track their indexes better than others.
Investors often spend much of their time focusing on an ETF’s expense ratio without taking into consideration the fund’s total holding costs.
For example, if an ETF charges only 0.20 percent a year, but it trails its underlying index by 100 basis points over a 12-month period, the ETF’s true holding cost over that period is actually 1 percent.
On the flip side, every so often, we have ETFs that outperform their underlying indexes due to sound portfolio management and a savvy securities-lending program. But more on that later.
In a simplified world, an ETF should trail its underlying index by roughly its expense ratio. But we all know that in the real world, other factors play a major role in tracking, such as optimization, trading costs, taxes and other expenses.
Many ETFs optimize their portfolios, or take a sampling approach, rather than replicating them exactly with the index. For international ETFs, managers can even hold American depositary receipts instead of the ordinary shares that are held in the indexes. These factors can cause slippage from the index on either the upside or downside.
Most investors prefer their ETF to track its index closely with consistency and minimal variability over time, but I also know of analysts who would argue that ETFs shouldn’t beat their indexes, and frown upon outperformance.
As an ETF investor myself, I don’t have any issue with an ETF that outperforms its index, as long as it’s done consistently and with minimal downside deviations. To me, these ETFs not only offer “free” holding costs to the investor, but provide additional gains, which I certainly won’t complain about.
We take ETF tracking seriously here at ETF.com Analytics. There are several ways to measure it, but we display “tracking” on our reports based on rolling 12-month tracking differences over a two-year stretch.
We display three measures: the median 12-month tracking difference; the max upside 12-month deviation; and the max downside 12-month deviation.
We display the max upside and downside deviations because we think consistency and variability is also of critical importance.
For example, if an ETF has a median tracking difference of only 0.10 percent over rolling 12-month periods, but it trailed the index by 1.50 percent over one specific 12-month period, that poses some serious problems for an investor who was unlucky to invest in the fund during that poor stretch.