ETF Tracking Error

In the Basics of ETF Investing article we provided you information about what an ETF is and how the work. The majority of ETFs are designed to replicate and track against a particular index, whether it's a broad index like the S&P 500 or a specific Sector or Industry.

One of the flaws in any investment that attempts to track and to beat an index is known as Tracking Error. A tracking error is when the return of the ETF falls short of (or excels) the benchmark return. Most ETFs tracking very closely to their benchmark as do indexed mutual funds. The individual fund manager, based on their investement strategy, can provide close tracking to the index or they can diverge (or less), but that's not necessarily a drawback [particularly when they exceed the benchmark]. There are three major factors that account for these errors:

• Sampling. Funds typically sample against the universe of the index rather than purchase all of the equities within the benchmark. A sample is merely a subset of the whole.

• Diversification Requirements mandated by the IRS or the SEC. Regulations on investment companies limit that a single company cannot represent more than 25% of a fund's total assets. If a company makes up more than 25% of a particular index then that company will need to be underweighted by the fund. In order to optimize the results of a portfolio the fund manager may overweight other assets within the index or they may even go outside of the index and invest in other assets.

• Expenses. Even if a fund identically tracks the benchmark, the expenses related to operating the fund will directly affect the performance, and lower the return by those expenses. Net Return = Total Return - Expenses.