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On the Right Track: Measuring Tracking Efficiency in ETFs

If you invest in ETFs, it's important to understand the factors that influence tracking error and tracking difference

Alanna Petroff 8 February, 2013 | 4:21PM

Beginning this year, providers of index-tracking funds such as exchange-traded funds (ETFs) will be required by European regulators to disclose predictions for their funds’ tracking error and tracking difference. These are the two most popular ways to see if ETFs are accurately tracking their designated indices.

Tracking error measures how consistently a fund is tracking its benchmark, while tracking difference looks at the under- or outperformance of a fund relative to its benchmark.

In response to this, Morningstar's ETF team completed an indepth study about tracking error and tracking difference for ETFs.

Below are some of the key findings from this report:

  • In general, ETFs have done well in limiting tracking error.
  • ETFs that use synthetic replication to track their indices typically produce lower tracking error compared to those that use physical replication. However, there is not a huge, direct relationship between tracking difference and a fund’s replication method.
  • An ETF's Total Expense Ratio (TER) is a very important factor in determining its performance relative to its benchmark. If an ETF has a high TER, the odds are good that it will also have increased tracking difference problems. But this is not the only determinant. Other factors such as securities lending income, cash drag, tax optimisation and rebalancing costs can all impact a fund’s relative performance. 

 

“Tracking error and tracking difference both play a part as complementary measures for assessing the replication quality of an ETF. As ETFs continue to gain in popularity, there is an increasing need for investors to be clear about these most commonly used metrics. In particular, there seems to be considerable confusion around tracking error, its meaning, key drivers, and calculation," said Hortense Bioy, director of passive fund research at Morningstar in Europe  

Other factors that investors should consider before buying an ETF include index construction, counterparty risk, bid-ask spreads, brokerage commissions and tax considerations.

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About Author Alanna Petroff

Alanna Petroff  is a financial journalist with Morningstar UK.