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ETF Specialist

Keeping Track of the Index Trackers

How do ETFs compare with mutual funds regarding tracking error?

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With so much risk in the markets, when we take a passive position in an index to form the core of our portfolio, we want to be sure that the fund company is actually doing what it promises it will do. One way to evaluate how closely a fund sticks to its benchmark is to look at tracking error. In this article, we compare two S&P 500 Index-tracking ETFs with a large sample of index mutual funds to see which products do a better job of tracking the index. Does paying a higher expense ratio result in lower tracking error or better performance? We also discuss different ways to define tracking error. We conclude that the S&P 500 tracking ETFs have performed as promised, with a lower tracking error and better performance than almost all index mutual funds. However, the granddaddy of all index mutual funds can still teach the new kids on the block a thing or two about efficiency.

We analyzed five years of weekly returns for 61 index mutual funds and two ETFs that track the S&P 500. The following table shows just the five mutual funds with the lowest tracking error and both ETFs. Two Vanguard mutual funds had the lowest tracking error, but one is an institutional product with a minimum investment of $5,000,000 while the other has a higher expense ratio, which leads to lower performance.

Michael Rawson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.