tracking differences and errors

Understanding tracking differences and tracking errors

The tracking differences and tracking errors are metrics that can aid in evaluating ETFs for a portfolio. However, to properly use the metrics, one must first grasp what each one represents and how much weight each holds in decision-making. 

When considering investment products, annualized fund returns are frequently one of the first things investors look at. However, the performance of ETFs compared to their benchmarks and competing products is essential. 

The tracking difference, which can be either positive or negative, indicates how well a fund has outperformed or underperformed its benchmark index.  

It’s derived by subtracting the fund’s total return from the benchmark’s total. Because a fund’s NAV total return includes fund expenditures, the tracking difference for index funds is often negative. 

The simple, hypothetical example below shows how two ETFs with the same benchmark’s average performance and negative tracking discrepancies compare to a baseline of their benchmark’s average performance. 

tracking differences and tracking errors
Tracking differences relative to a benchmark

Fund A was the better-performing vehicle, with a more significant average tracking difference. Fund B had a lower average tracking difference, giving investors a poorer return. 

The annualized standard deviation of tracking different data points is used to compute tracking errors. Tracking error reflects how much variability occurs among the individual data points that make up the fund’s average tracking difference. Tracking difference evaluates how much an index product’s return differs from its benchmark index. 

In our hypothetical example, the graph below depicts the data points that make up the averages. Tracking error is a metric that compares the distribution of individual data points to the average tracking difference of the fund. 

tracking differences and tracking errors
tracking differences relative to a benchmark

The tracking error for Fund A was more significant. It did, however, produce a better average return. The tracking inaccuracy for Fund B was more minor. The average return to investors, on the other hand, was lower. 

Using the tracking error and difference 

Maintaining tracking differences and tracking errors in context is critical when choosing the finest indexing ETF for a portfolio. If the total return is a significant criterion, tracking differences in evaluations will likely be more important than tracking error.  

If the consistency of performance is a priority, then tracking error may be a better option. 

What are some factors affecting a fund’s tracking of an index? 

Total Expense Ratio: The total cost ratio (TER) of an ETF is the single most accurate predictor of future tracking differences. If an ETF charges 0.5 percent to match an index, then ETF returns should trail index returns by precisely 0.5 percent, ceteris paribus. 

Transaction And Rebalancing Costs: Whenever an index’s components are rebalanced; a new company is added or removed. Thus, the ETFs that track the index must alter their holdings to reflect the current condition of the index.  

As a result, the ETF must rebalance its underlying shares, incurring trading costs in the process. These expenses are included and covered by the fund’s assets, which increases the tracking disparity. 

ETFs that monitor indexes with many stocks, illiquid securities, or frequently rebalance by design will have higher transaction and rebalancing costs, resulting in a more significant tracking gap. 

Sampling: Some ETFs choose to keep a representative sample of their holdings. The smallest securities have small weights and have no impact on performance in indexes with thousands of securities.  

ETF managers may choose to neglect some of those trivial securities to save money. This can lead to tracking differences. 

Cash drag: During the time between when the ETF gets a dividend and when it pays those dividends to owners, the ETF will experience cash drag. i.e., the lag between remittance or reinvestment will have an opportunity cost for the fund.  

Investors who want more significant long-term returns could prefer Fund A in the hypothetical case above. Despite its lower average tracking difference, short-term traders seeking higher performance consistency are drawn to Fund B.  

In other cases, the trade-off between tracking differences and tracking errors may not be as evident. A superior product would have a minor tracking error and a more significant tracking difference.

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