Scratching your head over why your exchange-traded fund (ETF) investment doesn’t exactly match the performance of its benchmark index? That’s where tracking error comes in. It's a handy metric that shows how closely an ETF follows its intended index. For long-term investors, getting a grip on tracking error be a useful tool for monitoring your investments.

When you pick an ETF, you're typically looking for it to replicate the returns of a specific index . However, ETFs often veer off course a bit. This deviation is what we call tracking error. Understanding this concept can help you see how well an ETF is managed and whether it fits your investment strategy.

In this article, we'll break down tracking error, explain why it happens, and discuss its impact. By the end, you'll hopefully have a clearer picture of how to use this information to choose the right ETFs for your portfolio.

What is tracking error?

Tracking error shows how much an ETF's performance differs from its benchmark index. It's a way to measure how well the ETF tracks the index it's supposed to follow. If the ETF and the index move together perfectly, the tracking error would be zero. But in reality, there are always some differences.

Calculating tracking error involves looking at the returns of both the ETF and the index over time. By comparing these returns, you can see how closely the ETF matches the index. Smaller differences mean lower tracking error, while larger differences mean higher tracking error.

Tracking error can happen for a few reasons. For starters, the ETF might not hold all the same investments as the index. Trading costs and other expenses can also cause differences.

By knowing what tracking error is and why it occurs, you can better evaluate ETFs before investing. This insight can help you decide which ETFs might be the right fit for your investment goals.

What causes tracking errors in ETFs?

As we hinted at above, tracking error happens for several reasons. Understanding these can help you see why an ETF might not perfectly follow its index. Let’s look at the various causes:

• Differences in index composition . An ETF might not hold every stock in its benchmark index. Some ETFs use a sampling method, selecting a subset of stocks that represent the index. This can lead to differences in performance.
• Management strategies and decisions . Fund managers sometimes make decisions that cause tracking error. They might adjust the portfolio to manage risks or take advantage of market opportunities. These decisions can create small deviations from the index.
• Trading costs and market impact. Buying and selling stocks incur costs. These costs can affect the ETF's performance . Additionally, large trades can move market prices, impacting returns.
• Dividend reinvestment timing and practices . ETFs and indexes might handle dividends differently. Timing differences and the approach to reinvesting dividends can both cause tracking errors.

How can tracking errors impact my long-term investing?

Tracking errors can affect your long-term investing in several ways:

• Performance deviation . Over time, even small tracking errors can add up. This can lead to your ETF performing better or worse than the index. Knowing this can help you set realistic expectations for your investments.
• Cost considerations . Tracking errors often come with additional costs. These can include trading fees or management expenses. Higher costs can eat into your returns, so it's important to be aware of them.
• Risk assessment . ETFs with higher tracking errors might carry more risk. If an ETF frequently deviates from its index, it might not be as reliable. Assessing this risk can help you decide if the ETF aligns to your investment strategy.
• Comparing funds . Tracking error can be a useful tool for comparing ETFs . Lower tracking errors generally indicate better index tracking. By comparing funds, you can choose the ones that best meet your goals.

Keeping an eye on tracking errors can help you monitor and understand how your ETFs are performing.

Real-life case studies of tracking errors

Case study 1: Vanguard Total Stock Market ETF

Vanguard’s Total Stock Market ETF (VTI) aims to track the CRSP US Total Market Index . Over several years, VTI showed a tracking error of around 0.05%. This small error was due to minor differences in index composition and trading costs. Despite the slight deviation, VTI consistently performed close to the index. Investors still benefited from the broad market exposure, but the small tracking error slightly impacted overall returns.

Note: The tracking error experienced by VTI in the past may not reflect future results. Market conditions and fund management strategies can change, potentially affecting future tracking error outcomes.

Case study 2: SPDR S&P 500 ETF

The SPDR S&P 500 ETF (SPY) is one of the most popular ETFs, tracking the Standard & Poor’s (S&P) 500 Index . At one point, SPY experienced a tracking error of about 0.1%. This error was mainly due to cash holdings and the timing of dividend payments. While SPY still provided strong exposure to the S&P 500, the tracking error meant its returns were marginally different from the index. Investors noticed this small discrepancy, which underscored the importance of understanding tracking error in large, well-known funds.

Note: The tracking error observed in the SPY historically is not a guarantee of future performance. Changes in market dynamics and fund management practices can influence future tracking errors.

These case studies show how tracking error can impact fund performance. Even well-managed ETFs can experience tracking errors, affecting returns. By being aware of these real-life examples, you can better assess the potential impact on your investments.

Are serious tracking errors common?

Serious tracking errors are rare in well-managed ETFs. Most ETFs are designed to closely follow their benchmark indexes, and fund managers use various strategies to minimise tracking errors. These strategies include efficient trading practices, dividend reinvestment, and managing expenses effectively.

Typically, tracking errors are small and don't significantly impact the ETF's performance relative to its index. This is especially true for ETFs that track well-established, liquid indexes. For instance, large, reputable ETFs generally exhibit low tracking errors because of their efficient management and large asset bases​.

However, tracking errors can occur and may become more noticeable during periods of high market volatility or when the ETF holds less liquid assets. Factors like transaction costs, management strategies, and the timing of trades can contribute to these errors. Despite this, the deviations are usually minor and tend not to drastically affect long-term performance.

Though it helps to keep an eye on tracking errors, don’t obsess over it. It's only one of many factors to consider when choosing an ETF . Understanding that serious tracking errors are rare can give you confidence in your investment decisions to stay focused on your long-term goals.

Also remember that past performance isn't a crystal ball. Just because an ETF has had minimal tracking errors in the past doesn't guarantee it will continue to in the future. Market conditions and management strategies can change, affecting future performance.

Before making any investment decisions, do your own research. Look at the ETF's history, management practices, and how it has handled past market conditions. Monitoring tracking error is just one piece of the puzzle. Make sure to also consider the bigger picture when evaluating your investments. And if you're ever in doubt, reach out to a licensed financial adviser.

Summing up tracking error

Grasping the concept of tracking errors can help you make better-informed ETF investment choices. While serious tracking errors are rare, being aware of them is crucial. Knowing how tracking error occurs and its impact lets you assess ETFs more accurately.

Remember, no single factor should determine your investment decisions. Consider the ETF’s overall performance, how it’s managed and if it aligns with your investing goals. Remaining informed and doing thorough research will guide you in choosing the right ETFs for your portfolio. This insight can help you stay on track with your long-term investment strategy.

Stay curious!