Tracking difference - sometimes referred to as excess return - and tracking error are important metrics to consider, especially when evaluating traditional index based ETFs. Understanding what they measure can help you make smarter investment decisions. Tracking difference measures an ETF’s performance against its benchmark index over a specific period of time. Calculating tracking difference is fairly 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. ETF providers define tracking error in different ways. The formal definition of tracking error is the annualised standard deviation of tracking difference. While tracking difference measures the amount by which an ETF’s return differs from that of its benchmark over a specific period, tracking error measures the variability of tracking difference over time.
For example, if the tracking error is 50 basis points, about two thirds of the time the ETF’s excess returns are expected to be within 50 basis points of the average excess return. A lower tracking error would suggest lower variability of the excess return. We believe that if your primary objective is seeking total return over a long term time frame, then excess return is a more important measure than tracking error.
However, over the short term, you may care more about performance consistency and want to minimise volatility, in which case you may wish to 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 higher 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 - that is greater negative tracking error. When comparing funds in real life, you may 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. What are the key causes of tracking error and tracking difference? In an ideal world, ETFs would perfectly track their benchmark indices. Tracking difference and tracking error would not exist. However, from a practical standpoint, four things make that ideal impossible to achieve.
Fees, management expertise, replication methodology and taxation. 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 trading costs which are not included in the ongoing charges figure or total expense ratio (OCF/TER). Swap fees, associated with synthetic ETFs, are also not included in the OCF or TER.
They can vary over time and consequently can be an important cause of tracking error and tracking difference. A good index fund manager will understand when to use a full replication approach and when a sampling or optimisation approach may be more appropriate. A manager must also be adept at handling index constituent changes, index reconstitutions, fund cash flows and more.
Replication methodology can be a major contributor to both tracking error and tracking difference. Fully replicated ETFs tend to have lower tracking errors than optimised and sampled ETFs. And finally, taxation. Depending on the domicile of the ETF, there may be withholding taxes both on dividends in the underlying portfolio and also on distributions of the ETF itself. Those taxes should be considered when analysing and comparing the performance of ETFs. Withholding taxes on dividends in the underlying portfolio are reflected in the ETF’s net asset value.
As a result, they also have a direct impact on an ETF’s performance and any tracking difference.
