ETF tracking errors: protecting your returns

Although the average investor rarely considers it, tracking errors can have an unexpectedly significant impact on investor returns. Before investing any money in it, it is important to investigate this aspect of any ETF index fund.

The goal of an ETF index fund is to track a specific market index, usually called the fund’s target index. The difference between the returns of the index fund and the target index is called the fund’s tracking error.

Most of the time, the tracking error of index funds is very small, perhaps only a few tenths. However, multiple factors sometimes combine to cause a gap of several percentage points between an index fund and its target index. To avoid such unwelcome surprises, index investors should understand how these gaps might develop.

Key points

  • The difference between the return of an index fund and its benchmark index is called the fund’s tracking error.
  • The SEC’s diversification rules, fund fees, and securities lending can all lead to tracking errors.
  • Tracking errors are often small, but they can still adversely affect your returns.
  • Check the fund’s beta and R-squared indicators to understand the possibility of tracking errors.

What causes tracking errors?

Operating an ETF index fund may seem simple, but in reality it can be quite difficult. ETF index fund managers usually use complex strategies to track their target index in real time, which is cheaper and more accurate than competitors.

Many market indexes are weighted by market capitalization. This means that the holdings of each security in the index will fluctuate according to the ratio of its market value to the total market value of all securities in the index. Since the market value is the market price multiplied by the outstanding shares, fluctuations in the price of securities will cause the composition of these indexes to change continuously.

Index funds must execute transactions in such a way that they accurately hold hundreds of securities based on their weight in the ever-changing target index. In theory, whenever an investor buys or sells an ETF index fund, all these transactions of different securities must be executed simultaneously at the current price. This is not reality. Although these transactions are automated, the fund’s buying and selling transactions may be large enough to slightly change the price of the securities it trades. In addition, the execution time of the transaction is usually slightly different, depending on the speed of the exchange and the volume of each security.

Types of tracking errors

Many different factors can cause or contribute to tracking errors.

Diversity rules

U.S. securities regulations require that the investment portfolio of any stock held by an ETF shall not exceed 25% of its investment portfolio. This rule poses problems for professional funds seeking to replicate the returns of a particular industry or sector. Really copying certain industry indexes may require holding more than a quarter of the funds in certain stocks. In this case, the fund cannot legally and completely replicate the actual index, so tracking errors are most likely to occur.

Fund management and transaction fees

Fund management and transaction fees are generally considered to be the biggest contributors to tracking errors. It is easy to see that even if a given fund tracks the index perfectly, its performance will still lag behind the amount of fees deducted from fund returns. Similarly, the more securities a fund trades in the market, the more transaction fees it accumulates, thereby reducing returns.

Securities lending

The main purpose of securities lending is to allow other market participants to short stocks. In order to short the stock, one must first borrow it from someone else. Usually, stocks are borrowed from large institutional fund managers, such as those who operate ETF index funds. Managers involved in securities lending can bring additional returns to investors by charging interest on borrowed stocks. The loan fund still retains its ownership of the stock, including dividends. However, the costs incurred create additional returns for investors that are higher than the index can achieve.

Generally, investors are advised to simply buy the index fund with the lowest fees, but if the fund does not track its index as expected, this may not always be beneficial.

Tracking error found

The key is to let investors understand what they are buying. Make sure that the ETF index fund you are considering does a good job tracking its index. The key indicators to look for here are the R-squared and beta of the fund. R-squared is a statistical indicator that indicates the degree of correlation between the price changes of an index fund and its benchmark index. The closer the R-squared is to 1, the closer the index fund’s rise and fall are to the benchmark’s rise and fall.

You also need to ensure that the beta of the fund is very close to the beta of the target index. This means that the risk profile of the fund is roughly the same as that of the index. Theoretically speaking, a fund can be closely related to its index, but it will still fluctuate at a larger or smaller amplitude than the index, which will be represented by different beta coefficients. Together, these two indicators indicate that the fund will track the index very closely.

Finally, a visual inspection of the fund’s returns and its benchmark index is a good health check of the statistics. Be sure to look at different periods to ensure that index funds track the index well in both short-term fluctuations and long-term trends.

Bottom line

By doing the simple homework suggested above, you can ensure that the ETF index fund tracks the target index in its advertisement, and you will most likely avoid tracking errors, which may adversely affect your future returns.

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