Does Your ETF Provider Reveal Tracking Error?

When choosing a passive fund, it is important to consider fees, replication method, whether the fund is accumulating or distributing and the tracking metrics

Kenneth Lamont 19 December, 2014 | 4:51PM

When considering an investment in an ETF, the sheer breadth of options available can be bewildering. Some of the key points of comparison that investors typically use when choosing between funds include index composition, fees, replication method and whether the fund is accumulating or distributing.

But when it comes to tracking quality, investors should focus on two key metrics: tracking difference and tracking error. These metrics are often used interchangeably but in fact they measure two very different things.

Tracking difference is defined as the difference in returns between a fund and its underlying index. Tracking difference is usually negative, meaning that the ETF underperforms its benchmark. Assuming otherwise perfect tracking, an ETF should underperform its benchmark by an amount equal to its total expense ratio on an annual basis. This metric is useful because it represents the total annual cost of holding the fund (note: it doesn’t include investor specific factors such as the cost of trading the ETF or tax considerations).

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author

Kenneth Lamont  is a passive funds research analyst for Morningstar Europe.

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