Limiting ETF tracking error

While you hear a lot about ETFs lately, you hear less about something called “tracking error,” which is the difference between the performance of a fund and the performance of the index to which its benchmarked.

Tracking error is a key indicator of the quality of an ETF — the lower the tracking error, the better — but it’s also unavoidable. There are three main factors that can increase tracking error to watch out for:

Management Expense Ratio – Everything else being equal, the higher an ETF’s management expense ratio (MER) — the amount of assets used to manage the fund — the higher the tracking error will be. Since all ETFs have management fees, the next best thing to a perfect ETF is one whose tracking error is caused only by its MER. Large, well-structured funds with plenty of liquidity come closest to achieving this goal.

But smaller funds, or funds that must invest in less liquid securities, can have tracking errors that are substantially higher than their MERs.

Liquidity and transaction costs – There are several reason why a tracking error may be greater than the MER. All ETFs, for one, incur costs when they rebalance to reflect securities that enter or leave a benchmark index. Many funds rebalance on a quarterly or semi-annual basis.

But perhaps the most significant non-MER factor in explaining why tracking errors vary is liquidity — or lack of it. ETFs that track large, liquid indexes enjoy more efficient pricing of securities. Bid/ask spreads are slim, and so transaction costs are kept to a minimum.

On the other hand, funds that invest in relatively illiquid markets or securities face higher transaction costs because of wider bid/ask spreads. Those spreads make for less efficient trades, higher costs, and therefore higher tracking error.

Sampling, or optimized strategy – To get around the illiquidity inherent to certain markets, ETF managers can use something called a sampling or optimized strategy, where the ETF invests in a reduced portfolio of securities (relative to the index). It’s selected so it should still closely replicate the return of the benchmark index.

This lowers transaction costs. But the practice, common in fixed-income ETFs, requires the manager to exercise more discretion, and therefore requires greater skill.

This approach introduces a gap between the ETF’s composition and the benchmark index, creating inevitable sampling noise, which can be reflected in higher tracking error. Good fund managers will limit the impact of that noise, but it’s rarely completely eliminated.

Assessing tracking error

Tracking error may be an indicator of poor fund construction or management, but there are other reasons for it as well.

For instance, an ETF that tracks the small and illiquid funds of an emerging-market bond is an excellent way to get access to such hard-to-reach markets. But, because of their illiquidity, the underlying markets will have higher transaction costs, which will increase tracking error.

Still, when compared with the other risks in the underlying markets, and the potential portfolio benefits, you might find a relatively high tracking error an acceptable cost of entry.

And, as these markets mature, it’s expected tracking error in corresponding ETFs will decrease.

In general, recognizing tracking error’s relationship with liquidity can be key to evaluating its significance in any ETF. In some cases, where the underlying market is relatively illiquid, a high tracking error might be acceptable; in others, where the market is liquid, a high tracking error might be cause for greater concern.

You’ll never find an ETF without tracking error, but understanding what it is can help you make better selections for your portfolio.