What affects index tracking?

Tracking difference (sometimes referred to as excess return) and tracking error are important metrics to consider when evaluating ETFs. Understanding what they measure can help you make smarter investment decisions.

 

Tracking difference

Tracking difference measures an ETF's performance against its benchmark index over a specific period of time.

Calculating tracking difference is rather simple: Subtract the index's total return from the ETF's total return.

Tracking difference can be positive or negative and reveals the extent to which an ETF outperforms or underperforms its benchmark index. Remember, since an ETF's performance includes its expenses, tracking difference is typically negative for ETFs.

 

Factors affecting tracking difference

Benchmark related factors	Negative	Negative/Positive	Positive
Index changes/turnover	x
Illiquidity of securities	x
ETF/fund related factors	Negative	Negative/Positive	Positive
Expense ratio	x
Other costs (e.g., commissions)	x
Sampling/optimisation method		x
Management skill and experience			x
Securities lending			x
Purchase and redemption fees (paid to fund)			x
Fair-value pricing		x
Cash drag		x

 

Tracking error

ETF providers define tracking error in different ways. Some simply refer to it as the difference between an ETF's return and the return of its benchmark index, which is really tracking difference. However, the formal definition of tracking error is the annualized standard deviation of tracking difference. In other words, while tracking difference measures the amount by which an ETF's return differs from that of its benchmark over a specified period, tracking error measures how much variability exists in the ETF's tracking difference.

For example, if the tracking error is 50 basis points, about two-thirds of the time the ETF's tracking difference is expected to be within 50 basis points of the average tracking difference. A lower tracking error would suggest lower variability of the tracking difference.

We believe that if your primary objective is seeking total return over a long-term time frame, then tracking difference is a more important measure than tracking error. However, over the short term, you may care more about performance consistency and want to minimize volatility, in which case you should focus on tracking error.

In the hypothetical example shown here, investors seeking stronger long-term returns may find Fund A the better choice, despite its high tracking error. However, investors who value returns that don't deviate too far from the benchmark may be attracted to Fund B, despite its lower average returns (i.e., greater negative tracking difference).

When comparing funds in real life, you might not find such a clear-cut trade-off between tracking difference and tracking error. Other factors, such as asset allocation, index methodology, and cost should also be evaluated before selecting an investment.

 

Key causes of tracking error and tracking difference

In an ideal world, ETFs would perfectly track their benchmark indexes, and tracking difference and tracking error would not exist. However, from a practical standpoint, a number of factors work to make that ideal impossible to achieve.

 

Fees

By creating a drag on performance, fees are the most common contributor to negative tracking difference. Be sure to evaluate all of a fund's fees, including the trading costs, which are not included in the expense ratio.

 

Management expertise

Not all index fund managers are created equal. A good index fund manager will understand when to use a full replication approach and when a sampling or optimization approach may be more appropriate. A manager must also be adept at handling index constituent changes, index reconstitutions, fund cash flows, and more.

 

Fair-value pricing

Fair-value pricing is a strategy designed to correct pricing discrepancies caused by time zone differences among the global financial markets. Fair-value pricing is applied because the market value may be stale and not a real reflection of the securities' actual (fair) value.

Some ETF providers use fair-value pricing if the value of a security it holds has been affected by events occurring before the local market's close but after the close of the primary markets or exchanges on which the security is traded. The policy is most commonly used when valuing foreign securities. Fair-value pricing can discourage short-term trading, which can drive up costs and, potentially, taxes for ETF shareholders.

 

Securities lending

Securities lending is a common practice among mutual funds, ETFs, pension funds, and insurance companies, which lend securities from their portfolios to broker-dealers, hedge funds, and investment banks in return for a fee. Collateral, generally in the form of cash and/or government securities, is delivered by the borrower in an amount greater than the loaned securities' value. In addition to the fee that a lender can generate from lending a security, the lender also earns interest by reinvesting the cash collateral.

Securities lending can benefit investors by offsetting some of the ETF's expenses, resulting in better performance. The degree to which securities lending benefits investors depends on how much of the lending revenue the fund company keeps.