Most ETFs track indexes. This means ETF investors can understand exactly how much it costs, all-in, to hold an ETF. ETF investors expect to get the index returns, minus fund expenses, with no surprises.
But it turns out there’s more to this story than you might expect. To tease out how well run—or how complex—an index-tracking ETF is, we generally turn to tracking difference, which is the performance gap between the ETF’s net asset value (NAV) returns and the returns of its underlying index. Alas, this measurement, while useful, can also be absolutely maddening.
In a perfect world, tracking difference tells the investor the exact difference between expectations (index performance) and reality (NAV total returns), excluding any trading costs. All else equal, we would expect tracking difference to equal the net expense ratio, plus portfolio management slippage, minus foreign dividend tax recapture, minus securities lending revenue. The problem is that all else is not equal. And it gets worse when NAVs are calculated asynchronously versus the underlying index.
First off, the actual ex-post expense ratio might not equal the ex-ante ratio stated in the prospectus.
Second, portfolio management slippage is real, but generally not made available to the public.
Third, foreign dividend tax recapture might not square with the underlying index’s applied withholding rate.
To cap it all off, some issuers calculate NAVs for non-U.S. equity funds using exchange rates taken at 4:00 p.m. ET, rather than the standard WM/Reuters 4:00 p.m. GMT (10:00 a.m. ET).
Put that all together, and you have a bit of an interpretation problem.
Where Tracking Difference Works
Nevertheless, tracking difference remains quite a useful tool. Here are a few ways you can look at it:
First, a simple case, where tracking difference tells you all you need to know about long-term holding costs: the three S&P 500 ETFs. Because the portfolios are limited to U.S.-listed stocks, you don’t have to worry about foreign tax withholding or fair valuation. Also, securities lending will not be a huge factor in the U.S. large/midcap space. So the differences in holding costs will come down to expenses and portfolio management.
|Ticker||Fund||Expense Ratio||Median Tracking Difference||Maximum Upside Deviation||Maximum Downside Deviation||Tracking Range|
|SPY||SPDR S&P 500 ETF Trust||0.09%||-0.08%||-0.03%||-0.19%||0.16%|
|IVV||iShares Core S&P 500 ETF||0.04%||-0.05%||-0.04%||-0.07%||0.04%|
|VOO||Vanguard S&P 500 Index Fund||0.05%||-0.04%||-0.02%||-0.06%||0.04%|