How to Evaluate ETFs With Tracking Difference and Tracking Error

Passive funds aim to mirror their benchmark indexes as closely as possible, making every basis point matter. But perfect tracking is a fantasy. While investors can expect index funds to mimic their benchmarks long-term, replication won’t be perfect every step of the way.

Tracking difference and tracking error indicate how well an index fund follows its intended path. While these metrics can be useful, investing professionals must consider their nuances to avoid common misinterpretations.

Morningstar researchers reviewed five case studies to assess how certain factors affect tracking values and trends. For the full breakdown of due-diligence examples, download the research report.

Tracking difference shows the magnitude of tracking performance gaps, while tracking error shows consistency over time.

Tracking difference is the gap between the performance of a fund and its benchmark index over a specific period. A -0.5% one-year tracking difference means that the fund’s net asset value, or NAV, lagged the index by 0.5% that year.

It measures how closely a passive fund has replicated the total return of its benchmark. High tracking difference suggests the fund deviated significantly from the index’s return.

Tracking error is the standard deviation of the absolute difference between the fund’s performance and that of its benchmark. A higher tracking error signals more variability in the fund’s tracking of its benchmark.

• Fees and expenses: Cost is the main driver of tracking difference. Among funds tracking the same index, pricier funds almost always post higher tracking difference. Fee cuts should decrease tracking difference over time.
• Index change or rebalancing: Changes to an index involve transaction costs. An index change can also lead to errors if you compare fund returns to an outdated benchmark.
• Securities lending: If allowed by the offering documents, securities lending can generate incremental revenue that can help to offset costs.
• Effective withholding tax rate: Funds may also benefit from tax treaties, with a lower tax rate on dividends than that assumed by the index. In Europe, for example, interest in synthetic ETFs is growing partly because of tax advantages.
• Fair value pricing: These adjustments to underlying securities’ closing prices address discrepancies that arise from the time between the fund’s jurisdiction and the market of underlying securities. This will result in higher tracking difference on a daily basis.
• Stale data: Errors in data entry can affect tracking error, especially when calculated more frequently.
• Cash drag: When funds hold a portion of their portfolio in cash, their returns can lag the index returns. But when an index falls, cash reserves can help fund returns.

Morningstar Direct offers nearly 50 data points on tracking difference, tracking error, downside tracking error, and average- and median-spread data.

You can delve deeper into ETF index tracking with Morningstar’s interactive research. Our approach addresses common factors that could affect tracking calculations. Compare up to 11 ETFs side by side over different time periods. Users can select a calculation benchmark, or the tool automatically defaults to the prospectus benchmark for the primary ETF.

These tools can help investors discern tracking difference and error trends that frame their due-diligence questions. Before making a conclusion, ask:

• Has there been a fee change?
• Could there be any data errors?
• Are you comparing the fund to the appropriate index?
• Has there been an index change?