One way to understand tracking error is to imagine a race between two cars where one car is the index and the other is the ETF.
The basic proposition of most exchange-traded funds (ETFs) is simple: replicate the performance of an index or its benchmark. However, some ETFs do this better than others.
Broadly, there are two ways to understand how successfully an ETF tracks it index: tracking difference and tracking error. The two are often confused. While related concepts, they are different.
Tracking difference is fairly straightforward. It describes the drags on performance produced by things such as management fees, rebalancing costs, cash drag and dividend distribution, as I explain in more detail here.
All these can result in the performance of an ETF being lower than that provided by the index. This is expected and no ETF will have zero tracking difference.
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Tracking error is based on this, but is slightly more complicated. Tracking error is about the difference of performance between the ETF's portfolio and benchmark. However, tracking error instead looks at the consistency and volatility of the difference over time.
The idea of tracking error is to measure the consistency of a portfolio’s tracking difference over time. To do this, tracking error looks at the standard deviation of daily returns of a portfolio compared to that of the underlying index. Basically, how often and how wide the performance of the portfolio deviates from that of the index.
So, a small tracking error indicates that the ETF will tend to follow its benchmark very closely throughout, whereas a large tracking error indicates the opposite.
Jose Garcia Zarate, associate director of passive strategies research for Morningstar Europe, offers a useful analogy to understand the difference between these two concepts. He asks us to imagine a race between two cars where one car is the index and the other is the ETF.
Zarate continues : “Tracking difference would be the time difference between the two cars at the finish line. Tracking error tells you how close the two cars were to each other during the race.”
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So which one should ETF investors care more about? As usual, it depends on what exactly your intentions and investment goals are. However, generally, if you are a long-term investor you should be more focused on tracking difference. The overall return versus the benchmark is more your concern, which tracking difference captures.
If you are more of a short-term investor, and expect to be buying in and out of ETFs, you may want to pay closer attention to tracking error.
Either way, a large tracking error or tracking difference should be seen as a red flag by investors. Large errors or differences potentially signal that the ETF in question incurs excessive trading costs (perhaps due to the complexity of its strategy) or the asset management firm running the ETF is charging very high fees.
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